Categories

My Account

Warning: You are using a browser that does not support angularJS. Some site functionality will not be available to you. Please consider updating to a newer version.

Gordon Gekko, the legendary character portrayed by Michael Douglas in Oliver Stone’s Wall Street, is listed 24th in the American Film Institute’s 100 greatest heroes and villains. If it weren’t for the fact that Ivan Boesky, one of the infamous convicted insider traders of the late 1980s, inspired the character, such a ranking wouldn’t be significant.

Unfortunately, Gekko’s place on the list represents what people think about insiders: individuals who trade on the basis of nonpublic information.

The idea that some people in the corporate world — the insiders — can make profits or avoid losses “simply” by trading on information not available to the general public often leads to emotional reactions. For example, when Federal District Court Judge Richard J. Holwell sentenced Raj Rajaratnam to 11 years in jail for insider trading, he said, “Insider trading is an assault on the free markets,” adding that “his crimes reflect a virus in our business culture that needs to be eradicated.”

This year, the Second US Circuit Court of Appeals in New York reversed the convictions for insider trading of hedge fund managers Todd Newman and Anthony Chiasson. This decision overturned the framework the government had relied on for decades to bring a series of successful insider trading prosecutions. Three months later, Rep. Jim Himes (D- CT) and Rep. Steve Womack (R-AR) introduced a bipartisan bill to ban insider trading, because “You would never say, ‘Let’s let the judges make the law around armed robbery.’”

But are insiders like armed robbers? Are they truly the villains of financial markets that we are told they are?

It might be the case that insiders are greedy people. Gekko’s famous line in the movie Wall Street, “Greed is good,” was borrowed from Boesky’s 1986 commencement speech at the University of California-Berkeley’s Haas School of Business. It might be the case that insiders care only about making profits and avoiding losses. However, borrowing Adam Smith’s words, is it possible that insiders, while pursuing their own gains, are “led by an invisible hand to promote an end which was no part of their intention?” Is it possible that “by pursuing their own interest they frequently promote that of the society more effectually than when they really intend to promote it?”

Once people understand the nature and role of prices, as well as how insiders, through their buying and selling decisions, rely on inside knowledge, they might see how such practices can help reinforce rather than hinder the market process.

Hayek and “The Use of Knowledge in Society

One of the greatest economics debates of the 20th century was the socialist calculation debate. Friedrich Hayek and Ludwig von Mises argued that centrally planned economies “in which the government controls all the means of production” could not be as effective as market economies in which the means of production are privately owned. Markets ensure allocation of goods and labor to their most valued uses.

Monetary prices can only emerge in a system where factors of production can be the objects to exchange for the purpose of allocating them to various alternative lines of production. Prices emerge out of the competition for resources with alternative uses that are valued differently by all individuals. Therefore, without monetary prices, there cannot be any profit and loss mechanism to help owners to allocate their resources effectively and efficiently in the economy.

Socialist economists such as Oskar Lange replied that planners could attempt to mimic the market mechanism by applying a trial and error procedure. But as Hayek pointed out, the decisions made by market participants that lead to price changes are not only based on scientific knowledge; they are also based on the “knowledge of the particular circumstances of time and place.” This local knowledge, Hayek argued, is the product of experience by those affected and cannot be communicated to a central planning board.

According to Hayek, prices convey more than just information about the decisions of myriad individuals; prices also convey the experiential knowledge dispersed among those myriad individuals — which they rely on to make their decisions. In other words, prices crystallize the local knowledge on which thousands of individuals rely to make their decisions.

Therefore, according to Hayek, the most significant aspect of the price system is “the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.” Without prices, individuals would have to acquire astronomical amounts of dispersed knowledge in order to decide where to allocate their resources or to make production decisions. As a corollary, when individuals can’t use their local knowledge to make decisions, it impairs the effectiveness of the price system. Because individuals’ local knowledge is no longer crystallized in those prices, the entire system gets distorted.

The use of inside knowledge in the stock market

Hayek’s insights on the nature and role of prices and, particularly, the importance of local knowledge, are fundamental to the appreciation of how insider trading can improve market operations.

Most insiders, whether they are directors, officers, or large shareholders, acquire the nonpublic material information in the course of their work. The information they use when they engage in insider trading is nothing more than Hayek’s “knowledge of the particular circumstances of time and place.” As a result, when insiders decide to buy or sell stocks based on the information they acquired in the course of their work, that local knowledge gets incorporated into stock prices, leading to price changes. These price changes can help other market participants make decisions, even if they don’t know fully why the prices changed. On the other hand, when insiders cannot trade or must hide their trades, the price signal gets distorted or delayed.

H. Nejat Seyhun and Michael H. Bradley looked at the data and found that insiders start selling their stocks as far back as five years before the corporation files for bankruptcy, suggesting that “insiders possess privileged information regarding the future price of their firms’ securities.”

If insiders’ informed sales provide us indirectly with information about their firms’ future situation, we can recognize that the same insiders play another but similar role: whistleblower. Donald Boudreaux suggests that insider trades serve the same role as whistleblowers, by communicating to minority shareholders and outside investors not to invest in the company.

“Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets,” writes Boudreaux. “The result is prices that lie.”

When prices lie, market participants are misled, causing them to behave in ways that harm themselves and the economy as a whole.

Viewed as a whistleblower function, insider trading could inhibit corporate frauds and, more particularly, accounting frauds such as the ones we witnessed with Enron. As Hayek explained, it really doesn’t matter why prices are dropping, other than indicating to market participants that there might be good reasons not to invest in a specific business.

José M. Marin and Jacques Olivier found that insiders’ sales prior to bankruptcies are not necessarily driven by a sudden need for liquidity or diversification. Their study shows that insider sales in the distant past are strong indicators of market crashes resulting from informed investors getting out of the market. But, because insider trading is illegal and the SEC closely monitors insiders’ transactions around events involving significant price changes, when insiders’ selling activity stops, it often means a market crash is imminent.

What these studies show is that insiders’ transactions communicate to the market their knowledge of the particular circumstances of time and place. This knowledge is crystallized into the stock prices and sends a signal to the market about how to reallocate resources.

Business insider

As Adam Smith taught us, there is little doubt insiders are self-interested when they make their buying or selling decisions using inside information. They intend only to enhance their “own security.” Their decisions also lead to an outcome they may not have intended to promote. Their self-interested but informed decisions improve capital markets, as well as intrafirm efficiency. Preventing insiders from using their unique knowledge distorts the signals that stock prices send to other market participants. That leads to greater market instability and, sometimes, more corporate scandals.

Real skills for professional success from successful entrepreneurs. Learn more  at FEEcon.org

Related Articles

{{relArticle.title}}

{{relArticle.author}} - {{relArticle.pub_date | date : 'MMMM dd, yyyy'}} {{relArticle.author}} - {{relArticle.pub_date | date : 'MMMM dd, yyyy'}}
{{article.BodyText}}

SIGN UP FOR FEE DAILY EMAIL