How bitcoin could stop insider trading

Investing has always been a war of information. Whichever traders have access to the highest quality of information are capable of making the most informed investment decisions and therefore have the highest probability of success. That's why before putting money on the line, professional investors spend countless hours digging through SEC filings, creating elaborate earnings models, and talking to every expert on a potential investment opportunity that they can find. Unfortunately though, no matter how many painstaking measures an investor takes to leave no stone unturned, all of his or her hard work can be undermined by corporate insiders acting on or sharing material nonpublic information.

There is no group of people on the planet that have a better incentive to stop insider trading than the other traders who stand to lose because of it.

Yuriko Nakao | Bloomberg | Getty Images

Alex Wilhelm, one of thousands who use computers to solve complex math problems and get their hands on the digital currency, has 30 remote-controlled servers mining virtual gold in an old brick building in the Austrian countryside.

The SEC plays an important role in financial markets as a regulator, but they don't have quite as strong of a motivation to stop insider trading as investors do. The SEC doesn't get punished in any concrete way whatsoever for failing to discover instances of insider trading. Meanwhile, investors have cash positions vulnerable to devaluation when insiders sell stock or advise others to sell illegally on material nonpublic information.

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In an ideal world we would have a mechanism for investors to catch each other and report insider trading to the SEC who would then act as the enforcer and prosecutor rather than an initial investigator.

Luckily, it's becoming more and more possible to imagine a situation where a similar system exists. Just as some new technologies including self-deleting text messages from apps like Mark Cuban-backed Cyber Dust or Confide could theoretically make insider trading easier to pull off, other innovations could help to shift the burden of discover away from the SEC to where it belongs — in the hands of investors.

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To be clear, new technology isn't necessary for insider trading either. Just last month, an incident came to light where a confidant would write down illegal tips on a sticky note, share the note with a trader, and finally eat the note to destroy the evidence. Sometimes the illegal information does not travel across the web or electronically at all. But there's one system out there that could someday be used to catch all forms of insider trading, no matter how the materially nonpublic information is shared. The system I'm talking about is the bitcoin protocol.

Holding bitcoin as an asset, currency, or whatever you want to call it may not make sense to everyone. But those who understand bitcoin well realize that the block chain as it's referred to, could be a game changing innovation even outside the realm of bitcoin.

Essentially, the block chain is a public ledger where all bitcoin transactions are recorded pseudonymously. We can all see every time a bitcoin moves from person A to person B, but we have no idea who person A and B are.

How it would work

Imagine a stock market where every trade had to be conducted on a public ledger like the block chain. If traders could see all the actions of other traders, it would be nearly impossible to get away with insider trading. Every institutional investor out there would develop algorithms to catch other traders who are engaging in highly suspicious or illegal activity. Next, insider traders discovered by the investors themselves would get reported to the SEC for further investigation and potential prosecution.

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Firms wouldn't need to give up the name tag associated with their trades either. Just like on the block chain, how we saw person A transfer a bitcoin to person B, we would see trade account A buy or sell a certain number of shares of stock without knowing who owns that account. The SEC could have its own method to privately identify the accused when sufficient evidence is presented.

It's not perfectly clear how the ultimate future of preventing insider trading will play out, but it's certainly not too early to start thinking about ways that we could improve the process. In a world where government regulators will always be one or more steps behind traders using the most cutting edge technology to cheat, allowing the community to police itself via the block chain would be game-changing.

Commentary by Leigh Drogen, the founder and CEO of Estimize, an open platform for financial estimates. Prior to Estimize, Leigh was the Founder and CIO of Surfview Capital, a New York based quantitative hedge fund. He was also an early member of the product and business development teams at StockTwits. Follow him on Twitter @LDrogen.