Free market solution to insider trading?

[Kashyap]

Face it, the buyer is the sucker in this transaction. He’s going long based on historical financial data, the insider is going short because the company is about to have a major negative event (like a recall) that will have a material impact on future earnings. Think Toyota.

The alternative to this being what? Say there is a lock-in period for insiders and the company’s future earnings are hit hard. Since the insiders cannot cash in before the fall in share value, they have every incentive to cook the books and engage in fraudulent accounting (think Enron) in order to maintain the share value. And they’ll eventually bail, making the shareholders take the loss. Anyone with such inside information has a great incentive to take advantage of it. It just cannot be prevented.

The fall out of this would be a cry for greater regulation of financial markets, causing more distortions in the market mechanisms.

In the long run, this would hurt both the “good” companies and the capital markets itself.

You might argue that the penalty for corporate fraud would be so high that it just won’t be done, that companies would be transparent in reporting their losses. If that’s the case, why should there be restrictions on inside trading at all? The markets would be better served by mandatory disclosures of share sales of the insiders.

You missed the point that when he bought the stock from the public, the public might not have sold for such a low price if they had been aware of the nonpublic information. They are the ones that should be upset.

This is speculation. And almost all market participants are speculators. And information is always at a premium. Information asymmetry cannot be vanquished by the wave of a regulatory wand.

What if the insider was wrong in his assessment of the information? What if the public benefited by offloading their shares to him at a higher price? That’s the risk the insider takes, for which he is compensated. Much the same way, the public takes the risk with regard to non-public information.

If insider trading was legal, do you think that the risk premiums would be the same as they would be if it was illegal?

Assessments of risks are always subjective. Risk premiums are set by different investors using different models. They keep evolving. They even take into account different types of risks and weigh them differently. The only answer to that would be: it depends.

Inside information doesn’t just get used by employees of a company. It also gets used by friends/family of the execs, who share it with their friends/family, who share it with their friends/family, etc. Basically, they don’t pay for information, while other investors have to pay for a lack of it.

But they do pay for information. They spend time gathering that information. And friends and family build goodwill with the insider in order to gain that information. Nothing is free.

And lastly, there are such things as private contracts which the employee can sign, which will limit their ability to indulge in such transactions. If a company has a record for such shady dealings, it will not be able to attract investors who do their homework well. Reputation matters. Regulations do nothing but waste taxpayer’s money on regulatory agencies, drain the wealth of companies faced with litigation costs and lawyer fees and do nothing to help the average investor. If a company does not go bankrupt due to its losses, it surely will after meeting these additional costs. Its a scenario where everyone loses, except the lawyers.

[M1ThinkTank]

Kashyap, I wish I could reply, but it is finally time for me to get back to the grind. Being a full-time student and full-time employee, my free time is few and far between.

To all who have posted in here today, thanks for the good debate. Hopefully, I will be able to log on again sometime in the near future.

Best regards,

TANK

[DD5]

@M1ThinkTank

You tell me that bank credit depends on the stock price. I tell you it doesn’t, that it depends on the financial statements.

Stock prices are both directly and indirectly related to a firm’s ability to raise new capital.

First, regarding bank credit, stocks and other investment assets are often used as collateral to obtain bank credit. That’s one direct link between prices and bank credit in general. Also, your financial statements of a firm are not some objective reports independent of stock value. The mere suggestion that they are is absurd. Stick to finance. I should have ended this conversation with you ages ago when you referred to intrinsic value, but I’ll respond perhaps one final time, not for your sake.

The higher the price of a share of stock, the smaller the share of the “pie” that must be given up by present stock holders in order to raise a given sum of money. Do the math if you are such a financial wizard. This makes it more likely for share holders to approve the issue of new stock and raise new capital. There are numerous way in which this affects financial statements and the prospect of growth for the firm. Such assessments for future revenue and growth are part of what credit issuers also rely on. The ability to raise new capital at lower costs on account of higher stock value provides leverage to executives that they would not have had if stock prices would have been lower. This ‘leverage’ directly affects the very financial statements that you think are some objective means to assess an apparently intrinsic value or something. This has nothing do with fraud or theft. Executives can conceal the current state of affairs or distort their significance for extended periods of time on account of such leverage.

The basis for the attack on inside trading is envy, purely and simply.

.

[Caley_McKibbin]

@M1ThinkTank

I’m not advocating a ban of anything else but insider trading

I don’t advocate banning anything but cigarettes. Everyone should be allowed to support only one type of aggression towards others.

Lame choices. I don’t advocate banning anything but inhaling oxygen. I sometimes slip and forget that it isn’t a strictly principled person in the argument.

[Autolykos]

M1ThinkTank, I think the debate over insider trading is really a debate over more fundamental ideas. It seems to me that you don’t understand the fact that value is subjective. I base this on the fact that you used the phrase “intrinsic value” in an earlier post. How can a share of stock in a given company have any intrinsic value, exactly? Of course, it can’t. But hopefully you see my point.

Now along with the fact of subjective value comes the fact that no one is entitled to any particular value for anything he owns. For example, I recently bought a house. The purchase agreement contained a clause stipulating that the sale would be null and void if the house appraised for less than the agreed-upon sale price. Had this clause not been in the purchase agreement, and the house ended up appraising for less than the sale price, I wouldn’t lose any money, because I never had it to begin with. Just because I happen to pay a certain price for something in no way means that, whenever I decide to sell it, the buyer is obligated to pay the same price or higher.

The same thing applies to stock markets. People forget that, when they wish to sell shares of stock, there must be one or more other people willing to buy them. Likewise, when people wish to buy shares of stock, there must be one or more other people willing to sell them. So the laws of supply and demand apply to stock markets as they do to other areas of exchange.

With that said, does it make sense to say, when no one is willing to buy what you want to sell at the price you want for it, that you’re being taken advantage of? What about if you buy a product at one price, without haggling, and then you find out another person bought the same product at a lower price, because he haggled? No, it doesn’t make sense either way.

[Valject]

Billy Enterprise: Hey! This looks like a good place for a restaurant! I’m going to build one. I’m also going to tell all of my potential competitors that this is a great spot, and explain to them exactly why I think so! I’m no inside-trader!

(Two Days Later…)

Billy Enterprise: Shit. Someone bought that spot. This is no longer a profitable investment for me. I wonder what happened?

At what point, exactly, are you obligated to tell people when you have a potentially profitable investment?

[MaikU]

^^ I was thinking exactly the same when reading this thread

[Valject]

Oh, thank god… For a moment I thought I was monopolizing the idea.

[M1ThinkTank]

Stock prices are both directly and indirectly related to a firm’s ability to raise new capital.

First, regarding bank credit, stocks and other investment assets are often used as collateral to obtain bank credit. That’s one direct link between prices and bank credit in general. Also, your financial statements of a firm are not some objective reports independent of stock value. The mere suggestion that they are is absurd. Stick to finance. I should have ended this conversation with you ages ago when you referred to intrinsic value, but I’ll respond perhaps one final time, not for your sake.

The higher the price of a share of stock, the smaller the share of the “pie” that must be given up by present stock holders in order to raise a given sum of money. Do the math if you are such a financial wizard. This makes it more likely for share holders to approve the issue of new stock and raise new capital. There are numerous way in which this affects financial statements and the prospect of growth for the firm. Such assessments for future revenue and growth are part of what credit issuers also rely on. The ability to raise new capital at lower costs on account of higher stock value provides leverage to executives that they would not have had if stock prices would have been lower. This ‘leverage’ directly affects the very financial statements that you think are some objective means to assess an apparently intrinsic value or something. This has nothing do with fraud or theft. Executives can conceal the current state of affairs or distort their significance for extended periods of time on account of such leverage.

The basis for the attack on inside trading is envy, purely and simply.

This whole post is comical. Just give up.

Nice strawman about the financial statements. I’ve said a million times in this thread that they were important for the stock price. Also, intrinsic value is real. It is what stockholders would pay for a stock if they could accurately predict all future cash flows. Of course, this is impossible to do, but material information (such as financial statements) about a company will greatly skew people’s opinions about a firm’s intrinisic value. As a result, material information that is made public causes great shifts in the stock price. Guess who gets in the door first, when material information is nonpublic? Finally, banks aren’t loaning based on the stock price, they are loaning based on the company’s ability to repay. I guarantee you that they are not looking at the stock price, not ever.

As for the part about the size of the pie and the stock price… hahahahahahah. The share price has absolutely nothing to do with the size of the pie that must be given up when the firm issues new stock. It has to do with the number of shares outstanding, so save your ad hominems about financial wizards for yourself. As a simple math example, if a firm has one share of stock worth $1 trillion, and they issue one new share, they give up 50% of the company. If a firm has 100 shares worth $1 each, and they issue one new share, they give away less than 1%. As you can see, stock price is totally irrelevant here. Besides that, I see you are making the case that executives can lie for extended periods of time without penalty. Again, Sarbanes Oxley. I’m tired of beating that dead horse.

Last, nice to see you close with another ad hominem. The last resort of a failed argument. You’ve made no good points, and even tried to use some false arguments against me (like claiming I didn’t know that financial statements affect the stock price… I’ve said the exact opposite multiple times in this thread).

Pleae stop wasting my time by claiming to have an idea about finance when you have proven time and time again that you do not. Here’s a list of your incorrect statements if you are unsure of your lack of knowledge:

• Bank loans are based on volatile stock prices
• Business contracts are based on volatile stock prices
• New investors can mysteriously buy stock without other investors having to sell it to them
• Executives can lie about financial statements without penalty
• The size of the pie that is given up when new stock is issued depends on the stock price

Of course, you’ll try to shift your arguments to make them seem more legitimate, but the fact that you remains that you actually tried to make these arguments, all the while telling me that I don’t know about finance. Laughable.

[M1ThinkTank]

Kashyap,

Seeing that you still only have two posts, I suspect you are a second account for someone else that has posted in this thread. Strange how you create an account, make two posts in this thread, and then never post again.

I’ve already answered all of your arguments in this thread, so please read the rest of the thread if you want to know my position on those issues. I’m sure it will be your second time reading them.

[liberty_student]

@M1ThinkTank

Kashyap,

Seeing that you still only have two posts, I suspect you are a second account for someone else that has posted in this thread. Strange how you create an account, make two posts in this thread, and then never post again.

It is not a second account. There are tons of articulate lurkers here. Your posts were begging for a rebuttal, you seem to fundamentally misunderstand libertarianism and Austrian economics.

[M1ThinkTank]

M1ThinkTank, I think the debate over insider trading is really a debate over more fundamental ideas. It seems to me that you don’t understand the fact that value is subjective. I base this on the fact that you used the phrase “intrinsic value” in an earlier post. How can a share of stock in a given company have any intrinsic value, exactly? Of course, it can’t. But hopefully you see my point.

I understand that value is subjective. I also understand that a share of stock has intrinsic value. It has intrinsic value based on the company’s ability to make money. If you were Nostradamus, and you could accurately predict a company’s future cash flows, you would know that company’s intrinsic value. Investors are not Nostradamus, but they try to be. As a result, when material information is made public, stock prices can shift dramatically in one direction or another because investor perceptions about intrinsic value change dramatically.

In short, intrinsic value is legitimate, since it is what investors are trying to estimate. They predict future cash flows, discount them according to a required rate of return, and hope that their assessment of intrinsic value is correct.

Now along with the fact of subjective value comes the fact that no one is entitled to any particular value for anything he owns. For example, I recently bought a house. The purchase agreement contained a clause stipulating that the sale would be null and void if the house appraised for less than the agreed-upon sale price. Had this clause not been in the purchase agreement, and the house ended up appraising for less than the sale price, I wouldn’t lose any money, because I never had it to begin with. Just because I happen to pay a certain price for something in no way means that, whenever I decide to sell it, the buyer is obligated to pay the same price or higher.

Thank you for stating the obvious. As for your first sentence, it is wrong in the case of insiders. If they could trade freely on nonpublic information, then they would almost always be entitled to much better prices for their stock than the average investor.

The same thing applies to stock markets. People forget that, when they wish to sell shares of stock, there must be one or more other people willing to buy them. Likewise, when people wish to buy shares of stock, there must be one or more other people willing to sell them. So the laws of supply and demand apply to stock markets as they do to other areas of exchange.

Again, thank you for stating the obvious. I already stated way earlier in the thread that this was true. But you neglect to mention that supply and demand is greatly impacted by the release of material information about a company. When nonpublic material information about heavy losses is used when an insider sells stock, he is selling when demand is based on public information. When that nonpublic material information is made public, all other investors must sell when supply and demand is based on the new information. In other words, they take a loss, the insider takes a profit (or mitigates losses).

In effect, insiders can make trades ahead of predictable shifts in supply and demand for a profit. (the shifts are only predictable to them, not to outsiders)

With that said, does it make sense to say, when no one is willing to buy what you want to sell at the price you want for it, that you’re being taken advantage of? What about if you buy a product at one price, without haggling, and then you find out another person bought the same product at a lower price, because he haggled? No, it doesn’t make sense either way.

Apples to oranges. In one case, someone is using negotiating skill to get a better deal. In the other case, someone is using nonpublic info to get a better deal. It has nothing to do with their investing acumen, just their access to information.

[M1ThinkTank]

It is not a second account. There are tons of articulate lurkers here. Your posts were begging for a rebuttal, you seem to fundamentally misunderstand libertarianism and Austrian economics.

And, if true, how does this make my arguments about insider trading invalid?

[AaronKilleen]

I get the impression that the concept of insider trading seems to be predicated on what can best be described as a “fair game” premise.

That is the stock market is supposed to be accessible to the public and everyone should get a fair shake in terms of stock selection and therefore everyone has a right to equal information.

One of my econ professors talked about a market for used cars he talked about lemons, he then said it happens in other markets and talked about lemon stocks. I guess one can imagine someone selling a stock just before announcing the company is declaring bankruptcy or something.

I don’t really agree with the “fair game” premise.

[M1ThinkTank]

Billy Enterprise: Hey! This looks like a good place for a restaurant! I’m going to build one. I’m also going to tell all of my potential competitors that this is a great spot, and explain to them exactly why I think so! I’m no inside-trader!

(Two Days Later…)

Billy Enterprise: Shit. Someone bought that spot. This is no longer a profitable investment for me. I wonder what happened?

At what point, exactly, are you obligated to tell people when you have a potentially profitable investment?

Obviously, you don’t share information about potentially profitable investments until those investments are made. I never said the company should be disclosing information that would hinder their ability to be competitive.

In fact, if you had actually read the thread, the debate is about whether or not insider trading should be legal. So the real question is, should Insider Joe be able to buy tons of shares from Average Investor Bob at a discount because Joe knows the company is about to buy some prime commercial real estate?

[liberty_student]

@M1ThinkTank

And, if true, how does this make my arguments about insider trading invalid?

If it relies on “intrinsic value” then it is invalid. Value is subjective.

[liberty_student]

@M1ThinkTank

In fact, if you had actually read the thread, the debate is about whether or not insider trading should be legal. So the real question is, should Insider Joe be able to buy tons of shares from Average Investor Bob at a discount because Joe knows the company is about to buy some prime commercial real estate?

Why shouldn’t he?

Libertarians don’t particularly care about legal. They care about lawful.

[M1ThinkTank]

I get the impression that the concept of insider trading seems to be predicated on what can best be described as a “fair game” premise.

That is the stock market is supposed to be accessible to the public and everyone should get a fair shake in terms of stock selection and therefore everyone has a right to equal information.

One of my econ professors talked about a market for used cars he talked about lemons, he then said it happens in other markets and talked about lemon stocks. I guess one can imagine someone selling a stock just before announcing the company is declaring bankruptcy or something.

I don’t really agree with the “fair game” premise.

One can imagine? It would be a certainty if insider trading were legal. It would be irrational for an insider to hold onto a stock that he knew was worthless.

The market for used cars is completely unrelated to the market for stocks. There are other factors to consider in the stock market that these oversimplified analogies ignore. One of them is the cost of capital. It would be higher if people suspected that insiders could rake in excess economic profits by trading on inside info.

That’s actually the one thing I don’t understand. I would assume that most people here would be in favor of perfectly competitive markets (which I absolutely am), but everyone seems to defend insider trading, which is essentially the same as having a monopoly on information.

People here hate copyright laws because it allows the holder of the copyright to charge higher prices than they would otherwise. Yet they love insider trading, which allows the holder of the inside information to charge higher prices than they would otherwise.

Mind boggling.

[Bill_Smith]

@M1ThinkTank

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.

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.

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.

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.

Net Share Purchase Activity

**Insider Purchases** - Last 6 MonthsSharesTransPurchasesN/A0Sales6,620,75016Net Shares Purchased (Sold)(6,620,750)16Total Insider Shares Held4.36MN/A% Net Shares Purchased (Sold)(60.4%)N/A **Net Institutional Purchases** - Prior Qtr to Latest QtrSharesNet Shares Purchased (Sold)(106,897,000)% Change in Institutional Shares Held(2.69%)

Data provided by Thomson Financial

This is a list of insider transactions for CSCO available on Yahoo finance. As you can see there are 16 sales and no purchases in the last 6 months by insiders. This is public information and you can trade on it if you wish. There are many reasons an insider may choose to buy or sell his stock so trading on this info alone is by no means a slam dunk way to profit.

[M1ThinkTank]

If it relies on “intrinsic value” then it is invalid. Value is subjective.

Yes, it is subjective, in the sense that it is an estimate of intrinsic value.

The fact remains that investors are trying to accurately estimate a stock’s intrinsic value, which, again, is the price you would pay for the stock if you had all information about that company’s future cash flows.