Currently the FBI is enforcing (attempting to enforce) free market conditions with its massive probe of insider trading:
http://www.guardian.co.uk/business/2010/nov/23/fbi-insider-trading-hedge-funds
The FBI has begun what is expected to be a far-reaching probe into insider trading with raids on hedge funds linked to some of Wall Street's most high-profile and wealthiest players. The sweep – which began with armed agents raiding the Connecticut offices of Level Global Investors and Diamondback Capital Management, both multibillion dollar hedge funds set up by former managers at Steve Cohen's SAC Capital Advisors – is already affecting stocks: a collective $15bn was wiped off the valuations of Goldman Sachs, Morgan Stanley, Citigroup, Bank of America and JP Morgan Chase.
The FBI has begun what is expected to be a far-reaching probe into insider trading with raids on hedge funds linked to some of Wall Street's most high-profile and wealthiest players.
The sweep – which began with armed agents raiding the Connecticut offices of Level Global Investors and Diamondback Capital Management, both multibillion dollar hedge funds set up by former managers at Steve Cohen's SAC Capital Advisors – is already affecting stocks: a collective $15bn was wiped off the valuations of Goldman Sachs, Morgan Stanley, Citigroup, Bank of America and JP Morgan Chase.
Is there a free market/propertarian answer for why insider trading would not occur in a Truly Free Market? Or is this news story vindication of Thomas Friedman's assertion that the "hidden hand of the market will never work without a hidden fist"?
Why would we not want there to be insider trading? As a superior Friedman said, "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that."
A handy rule of thumb: if the federal government does something, it is not in an attempt to foster free market conditions.
I think what most people would refer to as insider trading (ex: what Martha Stewert was accused of), most libertarians would not see it as a crime.
@ Michael Green:
What market incentives would there be for a person with insider information about a firm to share it with the public rather than with a small circle of associates?
Missing
the
point
.
Sorry to jump in, but I'll give this my take.
Why would there need to be an incentive for him to share information with the public?
The actions (such as buying shares, selling shares, exercising options) of an insider say plenty on his opinion of the company.
stock prices supposedly reflect the discounted value of payments associated with the asset.
to that extent, they serve as a type of signal for the prospects of the company. if stock prices are rising, that is telling you that investors believe that business will be good for the company over the foreseeable future.
by legalizing insider trading, you essentially make it more likely (so the argument goes) that the price of the stock serves a reliable signal to investors (if people inside the company know things are going bad, they will sell their stock for example forcing down the price).
of course, legalizing insider trading could change the incentives of ceos and other corporate execs. for example, at that point what would stop me from making a mint tanking my company and short-selling the stock?
so in that sense i don't think it is crazy to have insider trading laws. but one could argue that companys are better at policing their own ceos than the federal government. but i don't have a real opinion on it myself as i am not a finance or industrial org guy.
personally, i think stocks lost my interest when it stopped snowing on wall street if you get my meaning.....
coke. i'm talking about cocaine. i'm talking about back in the 80s when making money was fun. now your broker is more likely to be dropping adderall than than snorting blow. *sigh*
Ambition is a dream with a V8 engine - Elvis Presley
Referring again to Milton Friedman... buying/selling stock is how he shares it with the public.
It can be debated whether insider trading should even be a crime. It is neither a form of fraud nor theft, I fail to see anything immoral about it. What in your opinion is wrong with it ?
Agree with previous comment. It's like a problem created out of thin air.
(english is not my native language, sorry for grammar.)
There was a thread on this here:
http://mises.org/Community/forums/t/15987.aspx?PageIndex=1
Thanks DD5.
So, essentially, a CEO could buy 1m shares of a company at $40/ea. Investors see this as a good signal, and start buying the stock in droves, pushing the price up to $42.50/ea. The CEO then sells the 1m shares that he just bought, taking advantage of the lemmings that thought his purchase of the stock was a good signal. He nets a $2.5m profit practically overnight. Meanwhile, the investors that got to the party late try to sell their shares, realizing they have been duped. The last lemming finally gets out of the stock at $37.50/ea (instead of $40/ea), since the entire market demands a higher risk premium after the CEO's shady move. They all lose $2.50 per share, a 12.5% loss.
On the flipside: after a weak earnings report, a CEO sells all of his shares of a company at $40/ea, and investors panic, trying to sell their shares. The last lemming is able to get out of his position at $32 a share. The CEO then turns around and buys twice as many shares as he originally held at the lower price. The lemmings get back in line to buy the stock, pushing the share price up to $37.50/ea (instead of $40/ea) since the market demands a higher risk premium due to the CEO's shady behavior. The next day, a press release comes out announcing that the company had a major R&D breakthrough, giving the company the potential for massive earnings growth. The stock price jumps to $48/ea (would have been $50/ea without the shady behavior), netting the CEO a 50% profit.
As you can see, with legalized insider trading, nothing could go wrong.
Oh no! They knowingly and willingly risk their money and come out as losers? The horror! The unspeakable horror!
So, essentially, a CEO could buy 1m shares of a company at $40/ea. Investors see this as a good signal, and start buying the stock in droves, pushing the price up to $42.50/ea. The CEO then sells the 1m shares that he just bought, taking advantage of the lemmings that thought his purchase of the stock was a good signal. He nets a $2.5m profit practically overnight. Meanwhile, the investors that got to the party late try to sell their shares, realizing they have been duped. The last lemming finally gets out of the stock at $37.50/ea (instead of $40/ea), since the entire market demands a higher risk premium after the CEO's shady move. They all lose $2.50 per share, a 12.5% loss. On the flipside: after a weak earnings report, a CEO sells all of his shares of a company at $40/ea, and investors panic, trying to sell their shares. The last lemming is able to get out of his position at $32 a share. The CEO then turns around and buys twice as many shares as he originally held at the lower price. The lemmings get back in line to buy the stock, pushing the share price up to $37.50/ea (instead of $40/ea) since the market demands a higher risk premium due to the CEO's shady behavior. The next day, a press release comes out announcing that the company had a major R&D breakthrough, giving the company the potential for massive earnings growth. The stock price jumps to $48/ea (would have been $50/ea without the shady behavior), netting the CEO a 50% profit.
If shareholders know that they can get ripped off in this manner, why would they invest in the company in the first place? I don't understand the thought process here.
Appeal to ridicule... excellent argument.
So you believe it would be OK if CEO's and their friends and families could rob the general public at will, with no repercussions?
I'm sure that would do wonders for the capital markets.
They aren't robbing "the public". They aren't taking tax money when they do this.
They aren't robbing private individuals. Private individuals aren't forced to participate in this market.
(Well at least they shouldn't be. There are schemes that slice off some of their wages and stuff it into the stock markets. Then again, many of these are voluntary.)
You're right, they probably wouldn't invest. Clearly a negative for the capital markets, yet several here believe that the legalization of insider trading would be OK.
They aren't robbing the "general public". If they are robbing at all, they are robbing from other shareholders.
The real question is whether the arbitrary purchase of stocks will cause general investment in those same stocks. What magnitude of the total did this CEO buy? Would he risk that much money without knowing that the endeavour would be successful? What drives stock prices in a healthy stock market is large scale selling or buying on part of a large number of "speculators", not selling or buying on part of one speculator. These speculators usually have inside information, and so those who know that the CEO is trying to artificially drive prices up by stimulating demand will probably not invest in those stocks. This is their method of transferring information to others through the price mechanism in the stock market.
It's only when the stock market is "thin", as it was for example in the mid-1930s, that a relatively few number of speculators could cause wild fluctuations in the price of stock. The market was "thin" as a result of heavy government regulation on what was considered legal trading and what was not.
They aren't robbing "the public". They aren't taking tax money when they do this. They aren't robbing private individuals. Private individuals aren't forced to participate in this market.
By general public, I meant the people that only had access to publicly available information on a company.
Clearly a negative for the capital markets
I don't see how that necessarily follows.
They aren't robbing the "general public". If they are robbing at all, they are robbing from other shareholders. The real question is whether the arbitrary purchase of stocks will cause general investment in those same stocks. What magnitude of the total did this CEO buy? Would he risk that much money without knowing that the endeavour would be successful? What drives stock prices in a healthy stock market is large scale selling or buying on part of a large number of "speculators", not selling or buying on part of one speculator. These speculators usually have inside information, and so those who know that the CEO is trying to artificially drive prices up by stimulating demand will probably not invest in those stocks. This is their method of transferring information to others through the price mechanism in the stock market. It's only when the stock market is "thin", as it was for example in the mid-1930s, that a relatively few number of speculators could cause wild fluctuations in the price of stock. The market was "thin" as a result of heavy government regulation on what was considered legal trading and what was not.
You're right about the general public, I meant the investors that only had access to publicly available information.
Two questions though:
Some have made the point that legalized insider trading improves the price signal because insiders buying/selling shares can influence the price of a stock. In your post, you say that a few insiders making trades should not affect the price of the stock. Which is it?
Also, how do investors have any idea what my hypothetical CEO was up to? I never said that he informed others of his intentions.
A company needs cash for expansion. If we agree that legalized insider trading will spook investors, then investors will be unwilling to give their hard-earned cash to that company because they might get raked over the coals by insiders. As a result, it will likely be either very difficult to raise capital, very expensive to raise capital, or both.
The two are not mutually exclusive, and are actually one in the same. Inside trading involves more than one individual. It involves a large number of individuals, and sometimes can perhaps resemble a snowballing effect.
Also, how do investors have any idea what my hypothetical CEO was up to?
That's what "inside" trading is about.
If we agree that legalized insider trading will spook investors...
We don't agree. People only dislike "inside trading" when they lose money. "Insider traders" are the scapegoat everyone points to.
M1ThinkTank:By general public, I meant the people that only had access to publicly available information on a company.
What crime is being committed here when individuals are allowed to act on knowledge that only they possess, other then what the State has arbitrarily decreed as unlawful? I am particularly interested in what specific property rights are being violated here, and no so much in your objection on grounds of what you personally believe is fair or unfair.
I don't know where you are going with this. Insider trading can only occur when insiders trade based on inside information (i.e. information that other people are not aware of). This is wayyy before the information causes a "snowball" effect by reaching the average investor.
In other words, the CEO can sell his shares today, and tell his buddies to sell their shares, who tell their buddies to sell their shares, etc. Eventually, a lot of investors know, and the share price could potentially make a big move. The fact remains that the CEO cashed in first, screwing all the other owners. You're OK with this?
So let me get this straight. The CEO tells no one of his intentions. He sells all his shares. And somehow, people know his intentions?
What are you even talking about? I'm talking about capital markets, you're talking about something else entirely.
How's this: there are two firms of equal risk, size, and profitability. By law, executives of one firm can engage in insider trading, while exectutives of the other firm cannot. Which firm is likely to have the lower cost of capital?
You and I open a restaurant together. We agree that I will run the business, and I will only be required to provide you with quarterly financial statements so you can judge the business' performance. No other information must be provided.
One day, I sell my share of the company to someone else without telling you. Soon after, the local paper publishes a story about how several people got food poisoning after eating at your restaurant. Within a week, your restaurant is served with several civil lawsuits, and patronage decreases dramatically. You had planned on selling your share of the business when you retired, but now your investment is only worth pennies on the dollar. Meanwhile, I sold my share to someone for "perceived value" based on the financial statements. They paid for my share based on the public information, without being aware of the fact that lawsuits were on the way. Like you, they are also screwed.
I don't know what to call the right. But I do know that if I were in your shoes, I would definitely feel as if I had been taken advantage of.
It's not a question of first X amount of people investing with inside information, and then all of a sudden Y amount of people (the rest of the investing community) all of a sudden simultaneously investing their money in that stock. Trading in general doesn't work that way. It is snow ball effect; otherwise, prices wouldn't gradually change, they would suddenly reflect the final aggregate amount of money chasing that particular company's stock. There's different levels of investors, each investing when they receive enough information (either through the price mechanism or through "inside trading").
But the CEO is not the inside trader. The inside trader is the CEO's buddy, who because of the fact that they cashed out, they transmit that information to other investors through falling prices. Instead of everyone losing all of a sudden, the fall takes place gradually.
Inside trading is about those who knows the CEO's intentions, in this highly unlikely and mythical scenario of yours. The CEO will always be familiar with his own plans and intentions. You can't illegalize that. It would be like illegalizing breathing. Inside trading is what softens the blow.
No, the correct conclusion is that they probably wouldn't invest based on nothing more than seeing the CEO buy. They'd, you know, look at balance sheets and so on, and invest when they wish to purchase a portion of the ownership of the company.
I'm talking about the stock market. Inside trading is considered bad only when people lose money. They blame inside traders and speculators on their losses. Insider traders are not the root of those investor's losses.
What is true is that the firm with inside trader will be the most trustworthy over time, because it's the one where general investors will be able to enjoy prices which more accurately reflect the company's worth.
M1ThinkTank:.....[long story].......I don't know what to call the right. But I do know that if I were in your shoes, I would definitely feel as if I had been taken advantage of.
So do you accuse people of "robbery" and theft, which are nothing but acts of aggression against one's property, when you cannot even determine what constitutes those property rights in the first place? It sounds very tyrannical in nature.
Can I try to appeal to your sense of logic?
How does selling your "pre-owned" car not qualify as "inside trading"? There is a tittle of ownership being exchanged for money just like a piece of stock. It seems that everybody is engaged in "inside trading" for just participating in the market process and therefore, is committing a crime according to you. That long story of yours can be modified to reflect any exchange on the market.
Now, let's look at a situation the laws actually apply to. In a large stock market, people who buy the shares from the CEO are not being called on the phone and asked if they'd like to buy shares. They're calling their brokers and asking to buy shares. The only difference based on the fact that the CEO is selling is that they buy at a lower price, hence losing less money. As far as the partner is concerned, I have no idea what injury you're claiming for him. I would have lost my money anyway; how am I better off if you also lose?
I don't know why you stubbornly refuse to believe that the CEO can be an inside trader in a world where inside trading was legal. Further, you refuse to acknowledge that the CEO could sell first, it always has to be his buddy for some reason. Last, stock prices can fall pretty quickly once new information goes public. Look at how investors in CSCO reacted to the company's latest earnings report. The fact is, if insider trading was legal, the CEO and other select owners of the stock could sell their shares before the earnings information was public, allowing them to both to (1) sell their stock before it drops and (2) screw over whoever bought the stock with a capital loss.
Of course the CEO knows his own plans and intentions. I suggested a scenario where the CEO sold his shares without telling anyone why he was selling. In other words, they could not possibly know his intentions if he did not share them. For instance, imagine the CEO of CSCO sold his shares a few weeks before the most recent earnings were posted without telling anyone why. All investors who knew he had sold would have to speculate on his intentions.
The case would be hardly different if he told 24 other insiders that earnings would suck, and the group of 25 collectively sold their shares without telling anyone why. Other investors, again, have to guess why the insiders have sold. The insiders know why... earnings are not going to be so good, which will knock down the stock price. Only thing is, they get to sell before that information is public knowledge.
Amazing how hard people try to rationalize drastic action against people for making informed decisions.
Maybe not. But then they will wish they had when the CEO's company announces that they had an R&D breakthrough, and the price of the stock soars.
You definitely would have to consider other information about the company, but it's worth wondering... why would the CEO invest more of his own money into the company if he didn't think he would earn a profit? He's either trying to screw people over by making them bid up the price incorrectly so he can sell, or screw people over by buying a stock for way less than intrinsic value (because of something like a new R&D breakthrough) so he can earn better capital gains, not because of his investing acumen, but because of his access to non-public information.
Intrinsic value...
OK. So I was talking about capital markets, and you were going on some tangent about sore losers. And yes, inside traders are not the root of the investor's losses. However, the inside traders can get out before things get ugly and get in before business starts booming. AGain, it's not due to investment acumen, it's due to having information that no one else has.
Way to dodge the question while simulatenously making a false statement.
The fact that the price of a company's stock moves a little this way or that way is pretty irrelevant. What matters is the present value of the expected future cash flows of the company. If the average investor believes that a stock's present value is $40, and the stock drops down to $38, the average investor would probably buy the stock, since it is selling at a 5% discount to it's perceived present value.
Yes, one person could conceivably rake another person over the coals in a used car transaction. However, that is much different from insider trading.
I'll try to explain yet another way: two investors buy 100 shares of company X's stock at the same time for the same price. One of the investors has access to inside information, the other does not.
Which investor gets the better price on their stock purchase?
EDIT: I wanted to say something else about the car example. The person selling the used car presumably knows more than anyone else about the cars faults. However, an average investor selling his stock can only sell it based on whatever information he has been provided by press releases. If he sells it today not knowing that the company just secured a big contract that will boost the stock value, then he loses. The inside traders would not have such a disadvantage.