We should make insider trading a thing of the past

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On Tuesday, federal prosecutors in Boston charged eight men who spent almost a decade making global equity markets more efficient. A day later, two House Republicans held a press conference putting pressure on the House Speaker, Mike Johnson, to push ahead with congressional stock ownership legislation, which would also hurt price discovery.

That’s how I read these news stories, anyway. But I’m in the minority. For most, insider trading is unequivocally wrong.

Should it be illegal, though? Is it even bad? I would argue that insider trading bans are built on habit and groupthink rather than sound principles and real-world experience. Like shunning pineapple and beetroot on a burger. Worse, the rules are ineffective, illogical, inconsistently applied and — as I joked in my intro — market distorting.

Let’s start with efficacy. A research paper by Vinay Patel and Tālis Putniņš estimated that at least four times as much insider trading happens in the US as is ever prosecuted. Meanwhile in the UK, between 30 and 40 per cent of takeovers show abnormal price activity before announcements, reckons the Financial Conduct Authority. Yet there have been only a few dozen convictions in the past two decades.

So loads of people do it. What’s more, we’re all, you know, fine. Equity investors are richer than ever. Who are the victims, exactly?

Nor is there consistency on what basis insiders are prosecuted. The US, for example, doesn’t have a statutory definition of inside information. Everything relies on case-law doctrine requiring a “breach of duty”, whatever that means.

So it’s probably fine to short sell a listed restaurant after counting diners for months. How about paying an “expert network” to ask a mid-level employee how sales “feel” this quarter? Citing mosaic theory — in 1983 the Supreme Court ruled that investors were allowed to piece together small, legally obtained bits of info — may get you off. Take a scrunched-up copy of board minutes out of a bin? Busted.

It’s all pretty random. The rules in the UK and Europe are simpler and more consistent. Inside information must be precise, non-public and price-sensitive. But logic fails here too. Anything “publicly observable” doesn’t count, even if you are the only witness.

This is how sophisticated hedge funds can gain their “edge” versus investors such as you and me. Satellites analyse ore bodies in Australia. Programs track private jets to figure out what company might be buying another.

Is that fair? When I was a fund manager I had thousands of one-on-one meetings with management teams. Why do you think I did it? And what of chief executives who claim they are selling their shares “to meet personal commitments” such as buying a bigger house in the Hamptons. Yeah, right, boss. It has nothing to do with the rubbish earnings number coming up. Indeed, research is unequivocal that an investment strategy of shorting stocks that insiders have recently sold and buying stocks they have bought outperforms the market. There may be a lag, but it’s insider trading.

Hence why academics led by Henry Manne have long argued that allowing insiders to trade on material information moves prices towards their fundamental value more quickly — which is better for all. It reduces the mispricing borne by uninformed investors and improves capital allocation to boot.

“You want more insider trading, not less,” said economist Milton Friedman in 2002 for precisely this reason. Others such as researcher Frank Easterbrook argue for treating non-public information as an asset with property rights that a company should be able to allocate as it pleases. Sell to the highest bidder or let shareholders decide the price.

Insider trading becomes ever more efficient the more insiders there are. If only 200 pharmaceutical employees know that a drug has failed in testing, their combined selling is never going to move the share price to the correct lower level.

Legalisation of insider trading therefore requires absolute transparency — either in the form of real-time corporate reporting (which we’re light years away from) or the mandatory disclosure of everyone’s trades. Making job titles public would be a bonus.

Then we could instantly see if a treasurer has bought 100,000 shares a day before results. Clever analytics tools would soon learn that another buyer (his gardener, perhaps?) also has perfect timing. Their edge would be arbitraged away.

Ideally, historic transactions would be public, too. Very quickly anyone with insider knowledge would be tracked, even if they remained anonymous. A blockchain would make this easy.

Insider trading laws are not fit for purpose. They never have been. But we now have the technology to make the dissemination of information fairer for everyone.

stuart.kirk@ft.com