I don’t know much about economics. How does insider trading cause market failure?
It reduces confidence in the market and gives the impression that the prices are rigged.
Say you buy a stock, doing the research and finding it a good buy. The CEO gets to see information you can’t. Without rules, he could short his stock and make a lot of money, while you lose because you didn’t have access to the information he does. So that would make you reluctant to buy stock: why would you trust the market if CEOs could manipulate it based upon information they know beforehand.
The rules are set to try to level the playing field so that no one can benefit from knowing information that the general public doesn’t. (Note that the public can guess things about the company performance, but guessing is allowed: insider trading only affects people who know those things.)
I used to work for a company that was listed, doing desktop publishing. Some of the information I worked on (quarterly reports) contained information that would affect the stock. We also did research reports; one of them led to an SEC investigation that I had to provide material to.
Pretty simple - if the general public (or those who manage funds) don’t believe that the average company management is working for the best efforts of their shareholders, then they will simply not buy stock, or will only do so at a substantial discount.
This was the case in the good old days of stock marketing, where companies were regularly used to manipulate share prices and enrich the insiders - at the expense of investors who were screwed by the people who were supposed to be working for them.
Basically, the job of the CEO is to make the shares of Joe Shareholder as valuable as they can. If they play games and buy stock from a shareholder for less than it is worth (or sell short a contract) based on knowledge the rest of the market does not have - then essentially they are screwing the shareholder for their own gain. If your investment consultant makes trades for you, and uses his brother who charges twice the commission for any trade - and takes a side commission from the guys whose crappy mutual fund performs worse than the others- is he really doing his job properly, even if you actually make some money in the long run?
CEO or investment consultant, their job is to the best for ALL the people who hire them for that job, not to line their own pockets.
(“I suggest a new strategy called ‘churning’ which is designed to turn your idle cash into valuable commissions…” - Dogbert, from Dilbert)
The first thing to remember about economics is that a viable system is based entirely on trust. When you can’t trust things, the economy goes south. Money flows toward (perceived) reliable things.
Something of an aside: There is a scene in Wall Street (the 1980s original, not the 2000s or 2010s sequel) in which Bud, on instructions from Gordon Gekko, shadows the CEO of a competing investment firm. He observes that the CEO is travelling to Erie. Bud and Gekko conclude that there must be a takeover of or merger with a particular Erie-based steel manufacturer coming up, which is not yet publicly available information. They trade big on that knowledge, in full awareness that they are violating insider trading prohibitions, and later on these trades contribute to Gekko’s conviction.
I always found this part of the film rather ludicruous. I can’t imagine such a flimsy chain of conclusions, and acting on the basis of it, to be seriously seen as constituting insider trading in real life. But it seems to show that the concept is, I think, often interpreted too broadly by people.
Good points. I think I’m with most people here in that the purpose of insider trading laws is to require certain disclosures before trading, not to find scapegoats to punish for the fact that no one can truly peer into the soul of another.
It is also possible that the investigators will “find” evidence of wrongdoing even when none actually occurred, causing a catastrophic stock price fall favoring cautious public traders and disfavoring the “innocent” CEO now suddenly caught in a web of false evidence. Was it planted by a competitor? Were the investigators incompetent? Can he know? Can anyone who was not there truly know?
The “public knowledge” is that the allegations are false. Trading on that information is not insider trading.
If the “public knowledge” is not true, then the CEO is in trouble for withholding information.
If the “public knowledge” is not true, then the CEO is in trouble for inside trading.
If the “public knowledge” gets out of step with what the market believes. then it is the responsibility of the company to make a public statement. The stock market may suspend the stock, and demand a statement. (The CEO will be in all kinds of trouble if that public statement turns out to be false)
It is not in general the companies responsibility to make everyone sensible, or to make everyone believe the truth. Only to keep the market informed. The company (board and staff) must not encourage extrodinary public delusions, and may be required to try to correct them, but their explicit responsibilities don’t go much beyond that.