A Nightmare Scenario of Legalized Insider Trading: Time to Wake Up?

The idea of decriminalizing insider trading—and perhaps even removing some of the securities regulation rules that impose civil sanctions on insider trading—is finally becoming respectable.

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For a long time, legalization of insider trading was a cause restricted to a few libertarians, some hardcore efficient market types, and a handful of academics. But in recent years, the idea has gone mainstream—in part, I suspect, because the government’s costly and legally extravagant attempts to enforce the rules seem to have so little effect at deterring insider trading.

The backlash against legalized insider trading has already begun. One forcible critique comes from Bruce Carton, a former senior counsel in the enforcement division of the Securities and Exchange Commission who now runs Securities Docket—an online publication monitoring securities enforcement.

Writing at Compliance Week, Carton imagines what would happen if we let our ban against insider trading fall by the wayside:

Here is how I see life in Legalized Insider Trading (LIT) World.

First, in LIT World, the most important players in the global economy become people with early access to inside information. That is because such access will allow those who have it to legally make as much money as they want through insider trading with virtually no risk. If you know that a stock is going to leap up in value tomorrow due to a merger, some quick purchases of out-of-the-money call options will allow you to profit enormously.

Carton goes on to describe who he believes will become the “Kings of LIT World”—investment bankers, lawyers, auditors and other people with repeated access to non-public financial information.

Kings in LIT World will be approached daily by people seeking access to their information. In reality, they can probably ask any price they want for that information. You want a yacht? Sure. A million dollar house? No problem. Whatever a non-King has to pay can be recouped quickly and many times over through insider trading.

I think this vastly overstates the value of ‘non-public’ information in LIT World. Since so many professionals would have access to inside information and the ability to trade on it, it is likely that stock prices will be less subject to big movements due to a worse than expected quarter or an acquisition deal. That means the value of inside information to buyers of the information would be diminished.

What’s more, the growth of the supply of inside information legally available would diminish its value. Currently, much of the value of inside information is due to the scarcity, which is due to the ban. Legalizing insider trading would, in fact, make it less profitable to sell inside information.

More importantly, however, a world in which inside information is legalized would not necessarily be a world in which it is universally permitted. No doubt law firms, accounting firms and investment banks would set standards for trading and leaking information—many would probably ban this altogether. Already, many law firms go far beyond the law in banning short-term trading by attorneys—some ban short-term trading altogether.

Instead of a system of legally mandatory insider trading bans that can lead to criminal sanctions, we’d have an optional ban. The market would be free to price various types of bans as appropriate, rewarding firms that adopt levels of bans, monitoring or permissiveness that most meet the needs of their clients. If this seems too complex, we could even make insider trading bans the ‘default setting’—something that firms would have to explicitly opt out of if they chose to.

Violations of those policies could still subject individuals to sanctions, such as lawsuits or being terminated. What would change is that the vast regulatory apparatus established by our government to police insider trading would be largely dismantled, and criminal sanctions for insider trading largely abolished.

The nightmare scenario Carton describes is just that—a dark fantasy, with little connection to reality.

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