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A Free Market Approach to Insider Trading

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Tags Free MarketsEntrepreneurship

01/14/2014Fernando Herrera-Gonzalez

So-called insider trading may take place in publicly traded firms. It occurs when an individual privy to private information (the insider) attempts to profit on the buying and selling of stocks using non-public information to anticipate the stock’s future price.

For example: Mr. Povedilla, senior director of Joint Public Works Ltd., knows that JPW is going to sign an important contract that may increase the value of the firm and thus raise the stock price. By using this knowledge before it is public, he may buy stock of JPW and profit from the possible price hiking once the announcement is made.

Is Mr. Povedilla harming other investors and JPW stockholders by engaging in such practices? Many people may conclude that Mr. Povedilla is somehow “abusing” the person or entity from which he buys JPW stock prior to the announcement of the important new contract. Those who see abuse in this case may then advocate for legal controls on such activities.

However, such a legal solution is not as easy or appropriate as it may seem. First, it should be noted that the insider’s use of information is not risk free: even if those opposed to insider trading think that the insider will necessarily reap enormous rewards through the trade thanks to the privileged information, the truth is that the insider still needs to anticipate the market to profit, as in any other business opportunity. And there is always uncertainty on how the market will react to a new piece of information. Moreover, any number of other unexpected events may happen, causing the stock price not to behave as expected by the insider. The success of insider trading is not guaranteed, but subject to the same general risks incurred in any other transaction.

Second, the trading operation by the insider is a transaction voluntarily made by the counterpart. In other words, the individual who trades stock with the insider is doing so because he also seeks to profit from the transaction. Otherwise, he would not consent to do it. This implies that the counterpart believes he has information and analysis that the insider does not have. Taken to an extreme, it could be said of him that he is trying to “abuse” the insider. In fact, every one of us has private information, our own life experience, which makes us interpret in different ways existing market conditions.

Something seen as positive by someone may be perceived as negative by someone else. However, nobody would say that every stock trader is “abusing” those other parties due to the private information they may have.

Lastly, from a more theoretical point of view, insiders provide information to the market by means of their transactions. Thanks to them, this information reaches the market faster than it would without their involvement, which in turn accelerates the approach of stock prices to the real value of the stock. This process has been explained by Rothbard in his analysis of the social role of speculators.1Moreover, the mere fact that an insider wishes to sell or to buy provides information on the stock value.

Even if we accept that insider trading should not be banned, we might still consider what information should be provided by insiders (or affected firms) and the conditions (mainly, terms) in which it should be provided.

This problem can be solved by the stock markets themselves. Conditions imposed on insider trading (including its prohibition) should simply be features of each stock market. Thus, each stock market’s definition of what constitutes unacceptable insider trading should be in the hands of the owner or operator of the market. In turn, competition among stock markets, i.e., the “stock-market market,” would reveal the preferences among stock market customers in the matter of insider-trading rules.

If there is (or may be) competition among stock markets, that is, if firms can choose in which stock market to list their stock, they will prefer, ceteris paribus, those stock markets in which more investors (i.e., more possible buyers) participate.2 The number of participating investors of course depends on the conditions in which they can access information relevant for their investments, among other features. These investors may choose to buy stock in one or other stock markets depending on prices of transactions or, if they wish, on the conditions imposed to insider trading, or on other factors.

A firm which chooses a specific stock market in which to list its shares has to comply with the conditions required by the owner of the market, including those related to insider trading. Investors, in light of these conditions, choose in which stock market to operate. If they do not deem insider-trading rules to be suitable, they may go to other stock markets. In the same way, if a public firm prefers to carry out insider-trading without complying with the conditions of a specific stock market, it will have to look for another one in which to be listed.

In this way, it is the individual preferences of investors and firms that give shape to the requirements for insider trading, with no need of state intervention. This approach erases even the perceived need for legal sanctions against insider trading which had always been unfounded due to the fact that all parties take part in the transaction voluntarily.3 Of course, if the insider breaks any of the rules imposed by a specific stock market, it will be privately sanctioned by the owners of the market. After all, it is also in the interest of the stock market owner vis-à-vis participating investors to show that their rules are respected.

If we seek to eliminate or regulate insider trading, it is only necessary to allow free competition among stock markets while eliminating legal barriers to entry. The consumers will then determine the optimal conditions for its private regulation.4

  • 1. See chapter 2.7 of Man, Economy, and State.
  • 2. Stock markets are actually firms, which may be listed on stock markets as any other firm. In Spain, BME is the firm which operates stock markets.
  • 3. In Japan, insider trading was legal until 1988, and many Japanese do not yet understand that it is now illegal.
  • 4. Thanks to Professor Jesse Fried, from the Harvard Law School, for leading the workshop in which these reflections were born.

Contact Fernando Herrera-Gonzalez

Fernando Herrera-González writes from Spain. His Doctoral Dissertation applied Austrian economics to telecommunication regulation. He was granted the Victor Mendoza 2012 Award for Best Thesis in defense of the free market, by Instituto de Estudios Económicos. He has published in several peer-reviewed journals, and is possibly the first author to quote Ludwig von Mises in a journal related to telecom policy.

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