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May 9 2008 5:34PM EDT

Legalizing Insider Trading, With a Catch

Following up on Felix's case for why insider trading should be illegal, allow me to paraphrase another argument along those lines:

Imagine four types of investors:

- noise - those who trade on information they believe to be good, but is actually wrong (a large chunk of us)
- insider - those with intimate knowledge of the workings of a firm
- information - those who invest in finding information about firms (e.g. analysts)
- liquidity - buy and hold-type investors who don't care about the real economics of a firm. This group is likely to buy indexes of stocks. (another sizable group)

The tension among these four is between insider and information traders.

Let's say an insider sells some stocks. An information trader, not knowing the source of the transaction, will think that the stock is now undervalued so he/she will go long. Once the information that the insider traded on reaches the market, the info trader is toast. In the long run (and in the extreme), insider trading drives information traders out of the market.

What's wrong with this scenario?

The best argument is that insiders have the information but they may not be the one's best able to take advantage of it. The reason for this is that insiders are likely to only concentrate on their own business, or possibly their own sector, but not general economic forces. When information is made available to everyone at the same time, there is competition to get the most value out of it. And we know how much everybody likes competition.

As for noise and liquidity traders, the former aren't hurt one way or another by this dynamic. But the presence of info traders provides liquidity to the latter group.

Perhaps one solution could be to legalize all types of insider trading but with the stipulation that each and every transaction be made public. That way, insiders can attempt to both profit from and signal their information to the market.

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