Roth: Insider Trading Should Be Legalized

Roth: Insider Trading Should Be Legalized
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Former SAC Capital trader Mathew Martoma's insider trading investigation is just one of a bevy of high-profile insider trading cases that have come to light in the past few years and I think spending time and effort on these cases is a farce.

Should the allegations prove to be true, I am not advocating that Mr. Martoma be let off the hook because insider trading is currently illegal. However, what I am saying is that it is time to do away with the laws against insider trading entirely.

I do want to clarify that my argument focuses on the legality of trading on insider information. It should be noted that I do also believe that those with access to information should ethically and morally respect confidentiality agreements and fiduciary duties with the companies where they are accessing the information, but that is a separate civil, not a criminal, matter.

Now, many will talk about how unfair the market is and how insider trading creates an uneven playing field and the laws protect the little guy, but in reality, doing away with insider trading as a crime benefits all market participants.

Here's how:

Information makes the market more efficient: Information is the driver of market efficiency. While a perfectly efficient market will never be achieved, getting information to the market as quickly as possible helps to lessen the gaps of asymmetry and allow that information to reach a maximum of participants as quickly as possible. It smoothes out volatility, lessens the exposure to bad information and increases the exposure to good information, each of which benefits all market participants. Incentives, such as profits to be made from information, helps expedite that flow of information. Further, by eliminating insider trading as illegal, it will actually lessen the amount of profit to be made from seeking out the information by increasing the number of participants willing to do so.

(Read More: Insider Tweeting? Beware: The FBI Is Watching)

There's a gray area between proprietary research and insider information: While the case of Dr. Gelman tipping off Mr. Martoma that the Alzheimer drug performed a certain way in a clinical trial may be a clear cut example of insider trading, many times the line is blurred between information and research. For example, if I sent interns out to every Cheesecake Factory daily to talk to the managers, count traffic and interview customers in the parking lot and these interns reported back to me that sales were up at restaurants from month-to-month based on this activity, that's technically non-public information that was derived from research, and trading on that research is legal. However, if I had dinner with the CEO and he told me that sales were up from month-to-month before he put out a press release, that would still be non-public information but it would be illegal to trade on it. It's the same information, so should the methodology of retrieving it make a difference? No, the market doesn't care how the information was obtained, it only cares that sales are up.

Someone always has an advantage — in everything. Some argue that insider information creates an unfair disadvantage for the "little guy", the individual investor. I can't think of anything in life where something doesn't create an advantage or a disadvantage for someone. Fair only exists in fairy tales. The markets are inherently unbalanced. There are participants that have faster computers. There are participants with better algorithms and smarter staffs. There are those that transact a lot of business with certain investment banks who are going to get more favorable allocations in IPOs and follow-on offerings because they are better clients. So, someone is always going to have an edge somewhere.

(Read More: New Trading Case Casts a Deeper Shadow on a Hedge Fund Mogul)

Moreover, the little guy may not be able to take on the biggest market players with the best resources in the market (if you assume having money is the only measure of a resource, which it is not), but most little guys- the average investors- don't invest solely by themselves. They participate in mutual funds and pension funds, which do have access to larger monetary resources and who invest in firms with such access as well. So, when a SAC Capital benefits, endowments, pension funds and retirement plans also benefit. In actuality, the big guys thrive on information asymmetry, so eliminating insider trading restrictions would likely be at the expense of those major market players.

(Read More: Inside the Mind of An Inside Trader)

A Winner Doesn't Mean a Loser: How do you have a crime when there is no victim? When I trade in the market, I don't know who is on the other side of my trade as a buyer or a seller. Just because one side profits (or avoids losses) that does not have a direct impact on the counter-party, because my offer to sell or buy has no bearing on whether the counter party is interested in buying or selling. But my interest in taking or selling a large stake will eventually send a signal that is absorbed by the market and affect the price.

You Can't Enforce Inaction: If someone receives insider information, you may be able to prove when they acted on a piece of information, but you can rarely prove when they don't act. If I was planning to sell a stock, but received information that things were going really well and don't sell because of it, that's no different than buying for the same reason, except that you can prove the latter. The same thing for not buying something you were planning to buy but heard unfavorable information. I take issue with making something illegal when half of the outcomes are unenforceable.

Insider Information Doesn't Guarantee Outcomes: While you may be able to predict the outcome that a failed drug trial will have related to a stock, many times even if you knew the information, you wouldn't know how the market would react to it. A merger announcement may make a stock go up or down, depending on expectations. Even a positive sales announcement may not move a stock if that expectation was already priced in. We just don't know, so trading on insider information gives you one side of information, but not the other critical piece- how will other participants react.

While Wall Street's caricature reputation is that of unlimited greed, we need to look past the headlines and uninformed biases. When it comes to insider trading, getting better information into the market more quickly truly creates the best outcomes for all participants.

Tune In:

Carol Roth is scheduled to be a guest on CNBC's "Closing Bell" Tuesday, November 27, 2012.

Carol Roth is a business strategist, content producer, deal maker, former investment banker and author of the New York Times best-selling book, The Entrepreneur Equation. You can learn more onher website.