And so a fair degree of schadenfreude ensued when federal prosecutors charged SAC Capital with wire fraud and four counts of securities fraud yesterday. As my colleague Jia Lynn Yang explains, the indictment, "paints a picture of a hedge fund where a constant pressure to gain an edge in trading led to the widespread use of inside information, resulting in hundreds of millions of dollars of illegal profits."
Here's the thing though — those profits shouldn't be illegal. As unsympathetic a figure as Cohen is, and as sleazy as insider trading sounds, there really isn't much of a reason to ban it.
The first question when evaluating any criminal law ought to be, "Who does the practice this bans hurt?" After all, if the thing you're doing doesn't hurt anybody, the case for throwing you in prison — even "minimum security" prison — and subjecting you to all the horrors that entails is pretty weak. So who does insider trading hurt?
The obvious answer is uninformed investors. Let's say that I'm walking around the newsroom and hear that The Post is about to post really big losses for the previous quarter. I rush to my computer, log onto Scottrade and sell a bunch of my Post shares (full disclosure: I don't actually own any Post shares; hear that, Mr. SEC man?). When the stock drops following the public release of the loss figures, the poor schmuck I sold the shares to is out a bunch of money. He's the victim; I shouldn't have shafted him like that.
But wait a second — what was that guy doing buying and selling individual shares of The Post in the first place? Doesn't he know that your odds of beating the market as an individual investor are ridiculously low? He should just throw his money in an index fund like everybody else (and so should Dylan-for-the-purposes-of-this-thought-experiment, for that matter).
That's the problem with insider trading bans. They are justified as providing an even playing field for small investors, but obviously such a playing field doesn't exist. You really don't stand as good of a shot of beating the market as a guy with an E-Trade account as you do when you're, say, Steve Cohen. So you shouldn't try. Making insider trading legal would make it clearer to individual investors that picking and choosing stocks is a sucker's game, and deter more of them from trying, to their financial benefit.
Keeping it banned creates an illusion of fairness that leaves everyone worse off. Felix Salmon, arguing for bans on insider trading, wrote, "If you want a nation of shareholders, you need to give individuals some faith that they won’t get picked off like so many fish at a poker table." But we don't want a nation of shareholders — or we shouldn't, in any case. We want a nation of index fund holders, and banning insider trading makes that harder.
But that understates the case. Insider trading is actually an active good. Markets work best when goods are priced accurately, which in the context of stocks means that firms' stock prices should accurately reflect their strengths and weaknesses. If a firm is involved in a giant Enron-style scam, the price should be correspondingly lower. But, of course, until the Enron fiasco was unearthed, its stock price decidedly did not reflect that it was cooking the books. That wouldn't have happened if insider trading had been legal. The many Enron insiders who knew what was going on would have sold their shares, the price would have corrected itself and disaster might have been averted.
That's the argument of Henry Manne, an economist at George Mason University who's advocated legal insider trading for decades now. Referring to the Enron and Global Crossing's scandals, he says, "I don't think the scandals would ever have erupted if we had allowed insider trading because there would be plenty of people in those companies who would know exactly what was going on, and who couldn't resist the temptation to get rich by trading on the information, and the stock market would have reflected those problems months and months earlier than they did under this cockamamie regulatory system we have." And that's months and months where investors could have allocated money toward more promising investments, increasing market efficiency.
More formal economic models reach the same conclusion. Christopher Matthews at TIME — no relation — points to a study by researchers at the Atlanta Fed, who surveyed a wide array of models and found that insider trading makes stock prices more informationally efficient. Then again, it would deter some kinds of uninformed investors from participating — but again, that's a feature, not a bug.
What's more, insider trading bans don't actually stamp out insider trading. Illegal trading remains, of course, and may actually be growing, which puts law-abiding investors at a disadvantage. But the bans also exempt some equivalent behavior. Let's say that instead of hearing that The Post will post a loss, I hear that it'll post a profit, and thus don't sell any of my shares. That kind of "insider non-trading" is totally legal, but basically equivalent to insider trading. Allowing one and not the other is bizarre and inefficient.
Really, enforced insider trading bans are actually pretty new. Justin Fox at the Harvard Business Review notes that real enforcement in the U.S. began around 1961, and Matthews points out that the UK didn't do much to stop it until 1980. And many countries take a laxer approach than we do. Germany, France, Italy and Japan actually allow people in companies to provide tips to others legally, though acting on those tips could land the tipped-off party in hot water. It's hard to argue that the bans have done much to make U.S. and U.K. markets more scrupulous than they were in 1961 or 1980, and it's really hard to argue that they account for much of a moral difference between, say, American and Japanese trading cultures.
There's nothing really to lose from junking our insider trading laws, and a fair bit to gain. Let's start by letting SAC Capital do its thing and dropping the indictment.
SEE: The main players in the SAC scandal.