With the recent surfacing of alleged insider trading going on in Washington, I thought this would be a good opportunity to write a post about insider trading laws in general and their effect on the stock market.

Insider trading is defined as the trading of a corporations stock by people who may know information about the company that is not public knowledge. The idea behind insider trading laws is that they give everyone a fair chance to evaluate the information and decide whether or not to purchase shares in a corporation. It serves as a way to level the playing field.

There are significant problems with current insider trading laws, however. While a level playing field sounds wonderful, it's woefully unrealistic. The stock market is built on asymmetries of information -- a trader on Wall Street will almost always be more versed on topics of financial matters than a casual investor, bigger firms will spend more money to get more information, etc... Is that unfair? I don't think so. Would it be fair if your neighbor's wife was an accountant at some big company and provided you information about her firm? Certainly not any more or less fair that someone who wins the lottery. Unless fraud was committed as part of the transaction (a very difficult thing to do), the buyers or sellers of stock made their decision based on the information they had. The "insider" information available to one person would not impact the decision of another, especially today given that these trades happen in such an impersonal manner.

Another problem is that the laws are only targeting one side of the transaction. Investors make money knowing when to buy and sell, but also knowing when to hold. Just as many non-trades could happen due to inside information as actual trades, but this enforcement bias against only buying or selling unbalances the market. The message the SEC is sending is that you're entitled to rely on whatever information you can get your hands on so long as you do nothing. Such a rule is unlikely to improve investment decision-making or promote a more efficient market.

Moreover, what individuals see as unfair, markets see as necessary. The longer it takes for people to act on information, the longer it takes for the market to arrive at a real price. And, in my opinion, that's the largest harm caused by insider trading laws -- the laws increase the time it takes for people to act on accurate information. The longer it takes for the market price to adjust, the greater the price shock that will occur when the price adjustment occurs, which means more people will take greater losses. Consider a situation like Enron: Enron’s managers were using a garbage accounting methods to hide their losses. Several employees must had known some kind of shenanigans were afoot. That would have been a substantial incentive to dump their shares or even sell short. Such activities could have blown the cover off the whole scandal much earlier, possibly averting some of the massive losses people ended up taking.

There are limits on the release of inside information, however. Individuals and companies are entitled to withhold the release of proprietary information and punish those who violate that trust, but the offense should be civil, not criminal. And the punishment should be in line with the crime. There is no justifiable reason for government to get involved, or for its agents to use enforcement tools, like wiretaps and sting operations, to combat this non-violent crime.

So after all of that, should we allow the Congressmen to skate for their insider trading? I'd have to say no, but there might be individual circumstances where I could be convinced otherwise. In instances where Congressmen wrote legislation and/or positioned it in such a way that allowed them to profit greatly, that is such an abuse of power that serious penalties should be levied against them. In general it would seem to be a clear breach of ethics in which a Congressmen abuses the power inherent in his position for pecuniary gain.