Should Insider Trading Be Made Legal?

I'm simply raising the question. Could legal insider trading lead to a more efficient market that would ultimately benefit investors and allow investigators to probe elsewhere?
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On Friday, October 16, some very disturbing news came out. Billionaire hedge fund manager Raj Rajaratnam and several others are being accused of insider trading across several stocks. Phone calls were recorded, incriminating words were said. Its looking pretty ugly. Lots of questions remain unanswered. First, for me is, why would a billionaire who has clearly achieved great success in life and has already done many good things with his money, take such a high degree of risk. To risk even going to prison? We'll never know the answer.

But I also want to raise the question: should insider trading be considered a crime in a free market economy?

One of the stocks he is accused of trading with inside information (specifically, an analyst at Moody's was paid $10,000 to give up information that Raj made $4,000,000 on) was Hilton (HLT). On July 3, 2007, after the market closed, Blackstone announced they were buying Hilton. Raj had known and made a ton of money. Everyone knew at the time there was insider trading involved. I even went on CNBC that very weekend to discuss what had happened.

On July 2, the day before the deal was announced, Hilton shares were at $33.87. On July 3, Hilton shares made one of their biggest moves ever, closing almost 7% higher at $36.05 on double the normal volume before the deal was announced. And, by the way, it was a half day in the markets that day. Then Blackstone offered $47.50 a share for Hilton. It was clear even then that someone big had known something and had acted illegally on that information. In a column for the Financial Times I wrote "Certainly they'll catch one or two criminals here" and they did. Its very hard to track down insider trading and I give the SEC kudos for doing a great job here. Did they catch all the culprits? Probably not, but they certainly made anyone thinking of doing this crime very very scared.

But should insider trading even be illegal? The obvious answer is of course it should be, else the average investor will get taken advantage of. If some players in a market have an advantage, then some have a disadvantage and that's not fair. However, I'm not sure its so black and white. Here are the benefits of making insider trading legal:

  • The more information in a market, any market, the more efficient prices become. If informed investors start buying or selling based on privileged information, asset prices will rise to their "correct" level. For instance, in the Hilton case, we probably would have seen a smooth progression of the stock price from33 to45 over the prior month as talks progressed, instead of the spike in just one day.

  • Fraud will be exposed earlier. This is a very key point to the argument. Enron is an example where tens of thousands of investors got burned because they were piling into the stocks during the later stages of its fraud. If insiders were selling we would've seen a much swifter move down, and probable fraud exposed.
  • Companies will either become more transparent, to keep the retail investor happy, or will themselves enforce secrecy rather than being complacent with the idea that the law somehow protects their secrets.
  • One concern is that there will be a flight of liquidity because people will be concerned about the legitimacy of our markets. Rather, the opposite will occur. More enforcement dollars will be used to uncover actual frauds such as the next Enron or Worldcom. Arguably, these frauds are a thousand times more dangerous for the retail investor than what is probably a victimless crime such as insider trading.
  • Insider trading is almost impossible to prosecute and the government wastes countless dollars trying.
  • I'm simply raising the question. Could legal insider trading lead to a more efficient market that would ultimately benefit investors and allow investigators to probe elsewhere? I'm scared about all the ponzi schemes, the mini-Madoffs, left uncovered. What do you think?

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