Yglesias Gets It
What you hear is that [insider trading] rules are in place to protect investors from getting ripped off. But I don’t think this really stands up to scrutiny. That makes it sound as if the purpose of the stock market is to create an entertaining casino that people want to participate in, thus letting the house get a bigger rake. And of course it’s true that if that were the purpose of the stock market you would want rules against insider trading. But that’s not the purpose of the stock market—at least not the legitimate purpose. …
I looked around on this and found that Fama & French believe in the insider trading ban. Frankly, when you find a regulation that business-friendly academics who never want to regulate anything like, I’m even more inclined to believe that this is a worse idea than it sounds. Basically it’s a government seal of approval on stock market speculation, when the government should not offer any such seal. (more)
I used to give more benefit of the doubt to the argument that more insider trading would produce less net stock investment. But that effect seems pretty weak to me, and firms which thought it especially an issue for them could ban insider trading via contract.
While it is true that allowing insider trading would provide more information to the markets and thus make price discovery more efficient, it would provide much stronger incentives to prevent information that is today routinely disclosed from becoming public. The officers of a large corporation would have a strong incentive to ensure that any bit of material public information is given to his network of investors as far in advance of that information becoming public as possible to allow those investors to buy or sell long before the information became public. Each of them could generate large private gains either in direct payments from their network of investors or, more realistically, in various sorts of in-kind consideration. The officers of the largest corporations could presumably make far more bartering inside information in their company than the company itself would be willing to pay them when you consider the value of that information to large hedge funds and allow a legal bidding war to take place.
The possibility of insider trading would also tend to make the market far more volatile and make panics more likely. If I see a family of fund managers selling off their positions in a company, there are many possible explanations today. If insider trading were legal, however, you'd see rampant and credible rumors that the company running the funds knew something material which could easily set off a panic. Obviously, not every sale would set off a panic, but it increases the probability substantially.
Insider trading is banned in PUBLICLY TRADED companies. I don't believe it is banned in private companies. There are limits on exploitation of intentional information asymmetry in all trades, I think, with fraud laws being the ultimate limit.
Publicly traded companies are essentially agreeing to a broad range of behavior limits in exchange for access to a large pool of stupid money.
We don't require (or even allow) every idiot in New York City to carry a gun in order to protect himself from street crime, instead we have "regulators" (police, jails, courts) who protect the large pool of stupid people who then gain access to New York. Essentially, deciding to go in to New York to make money or be entertained or whatever is agreeing to be in that environment. The environment appears to be successful largely as a result of the high level of "regulation."
Similarly to the public stock markets. Whatever your Austrian theory might be, no one can argue against the coincidence of 1) tremendous regulation with much of it about transparency, including insider trading restrictions and 2) tremendously large piles of money available in these markets.
Robin speaks dismissively of the purpose being to build an attractive casino. But of course whether you approve or disapprove, it is only the attractive systems we spend much time discussing because these are the ones which are heavily populated, these are the ones that matter. Bans on insider trading and other regulations and laws towards transparency, limiting information asymmetry, will ALWAYS be imperfect. But the evidence on its face is that a lot of limits are way better than a few at creating a gigantic pool of stupid money, some of which, perhaps accidentally, winds up used for the good of society.