This post originally appeared on TraderPlanet.com.
Currently SAC Capital, the hedge fund run by everybody’s favorite Market Wizard Steve Cohen, is at the center of an insider trading scandal. I won’t go into the details because they pretty much follow the pattern of every similar scandal….
Double secret information is leaked. Accused defendant allegedly trades on it. Federal prosecutors try to prove who knew what and when. The guilty parties go to jail and the story gets turned into a made for TV movie. See Ivan Boesky, Michael Milken, Martha Stewart, et al.
However, what’s really fascinating about these scandals when they arise is how a small but vocal minority come out of the woodwork and uses these events to argue for the legalization of insider trading.
In all honesty, it’s hard to take these people seriously. Their articles on the subject just seem like an excuse to create “link bait” type headlines that belong in the same category as “Should Firemen Just Let Fires Burn” and “Why Can’t Pre-teens Smoke Cigarettes.”
In that vein, CNBC recently ran this article on their site entitled;
The author, Carol Roth, goes into a number of different reasons why she thinks that we should do away with the criminality of insider trading. But at the risk of being hyperbolic; legalizing insider trading would be the all-time worst decision in the history of mankind.
Okay, perhaps that IS a bit hyperbolic, but I have to take issue with Mrs. Roth’s stated contention.
In her article she suggests that both those who knowingly give insider info (the “tipper”), and those who trade on that info (the “tippee”), should be free from criminal prosecution; and that only the “tipper” should be subject to civil charges if they have violated any confidentiality agreements or fiduciary duties.
Look, I’m not a lawyer. I don’t even play one on TV. But this “hybrid” sort of arraignment seems like a prima-facie mess to me (Latin, pretty cool, huh)? Let’s start with the “practical” issue first
For arguments sake, let’s say that there are currently one thousand hedge funds, mutual funds, or similar entities in existence right now that would benefit from insider information. And let’s say that of those one-thousand, five percent of them are currently and actively trying to get insider info to trade off of.
The other ninety-five percent stay away from insider trading for fear of what would happen to them if they were caught, which we all know can include massive fines, loss of access to the markets for life, and most importantly, prison time.
Now let’s pretend that the laws against insider trading are eliminated in the way Mrs. Roth suggests. At exactly 12:00:01am on the day those laws are eliminated, all one thousand entities would now be actively and aggressively engaged in the business of acquiring insider info.
You have now created a market style ecosystem for insider information, with the problem being though that you have unleashed a massive demand for it, but only have a static supply. Insider info is not a product or commodity that you can ramp up in order to meet increased demand, and thus that insider information becomes exponentially more valuable than it currently is.
Those wishing to trade on that inside info could then freely “incentivize” the gatekeepers at companies, labs, ratings agencies, government organizations (think FDA), and so on, to give up that information, with no threat of recrimination.
In essence you’ll create a bidding war where the prize goes to the highest bidder, which will draw out people who normally would never think about divulging confidential info, but now might take the risk because of the outsized reward.
And since you have removed the criminal liabilities for the “tippee,” chances are there will be a price point at which many of them will give up their precious info knowing that it would now be even harder for them to get caught.
When you trade on insider info there is a physical record, the trade itself, of what you did, which gives prosecutors objective evidence to charge you with. However, when you just “give” insider info to someone who trades on it, there is usually no physical record of that act.
In fact, most “tippers” are found by starting with the “tippee” and working backwards. Since that “tippee” would no longer be a target, the evidential lifeline to most “tippers” would evaporate.
But even if you did catch them, how would the consequences play out in the real world? Sure, if a corporate executive gets busted for giving up info in return for a suitcase full of cash chances are nobody will pity him. But say some middle manager at a publically traded company gives Mega Global hedge fund a tip because they sent him and his family to Hawaii for a week.
How will that look on the evening news when the S.E.C. goes after him civilly for a $2,000 vacation while the principals at Mega Global, who made $100 million trading on that info, sit with impunity at their Swiss chalets, lighting cigars with hundred dollar bills?
This of course is where we get into the “theoretical” problem with decriminalizing insider trading.
Ever since the dot com bubble busted in 2000, retail traders have been leaving the stock market in droves; something only hastened by the carnage of 2008, flash crashes, and the rise of high-frequency and algorithmic trading.
The average trader sees the market increasingly as a “rigged” game, one in which they have little or no chance to win at. The message we should be sending with our actions is one that encourages individuals to come back in to the markets, not reinforces their belief as to why they should stay away.
And even if the benefits of legalizing insider trading technically outweighed the drawbacks (which they don’t), the message that would be sent to the individual trader would be something that starts with the sixth letter of the alphabet, and ends with the twentieth.
And it’s not “friendly emu.”
Brilliant stuff like this rains down like..well, rain, on my stream during the week. If you want to get wet, follow me on Twitter and StockTwits. You can also pick up my book Trading - The Best of the Best: Top Trading Tips For Our Times by clicking here.