Currently the FBI is enforcing (attempting to enforce) free market conditions with its massive probe of insider trading:
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.
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?
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
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 ?
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.
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.
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.
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?
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.