A Helpful Insider - Welfare Implications of Insider Trading

Is there a correct way to regulate insider trading? Professors Luis Angel Medrano and Xavier Vives develop a model that links the impact of insider trading to the precision of the information itself. The model calls for public policy to be more innovative as there isn’t a one-size-fits-all regulatory regime that can balance the consequences in different situations.

by Xavier Vives, Luis Angel Medrano
Last Updated: 23 Jul 2013

More and more countries are regulating insider trading. There is evidence that enforcement of insider trading laws reduces the cost of equity in a country. However, the laws in themselves are unable to completely stop the phenomenon, as there is evidence that insiders continue to trade in advance of information release and earn excess returns. There has been a significant debate on the “right way” to curb insider trading – Is the US-style disclosure regime the way to go or should companies be allowed to resolve this internally.

Surprisingly, despite all the unease about insider trading, the overall impact of regulating (or not) insider trading is less well understood. To resolve this, Professors Luis Angel Medrano, at Universitat Pompeu Fabra, and Xavier Vives, The Portuguese Council Chaired Professor of European Studies and Finance at INSEAD, build a model aimed at providing an appropriate regulatory framework for insider trading.

Imagine the following scenario. An entrepreneur, or a coalition of insiders, has a project that needs investment, which is obtained by selling shares of the firm in the market. After the investment is made, the entrepreneur/insider happens to obtain valuable information, about the effectiveness of a new drug that will be shortly released to the market. In a ‘disclose-or-abstain’ regime, the crucial question would be, has the insider paid for the information? If the information was received at no cost, he has no dilemma in disclosing it and subsequently trading. However, if there is a cost associated with information procurement, he may choose not to invest in it, as he will be required to publicly disclose it within the legal framework.

In general, insider trading leads to a decrease in investment. It impacts the stock price, the market depth, and risk premiums. However, the precision of this information can create different effects. Precise information acquired at no cost sends a signal to the market that can actually lead to an increase in investment. The level of precision also has differing level of impact on the players in the market – for example, with an intermediate level of precision, insider trading hurts everyone except the hedgers.

The paper also shows different public policy implications. At times insider trading is useful, as in the case of highly volatile industries, and a laissez-faire approach would perhaps be better. In general, when information has a cost associated with it, an abstain-or-disclose rule is better; free information is better managed with a laissez-faire policy. This also leads to the conclusion that laissez-faire would be more appropriate way to manage sharing of advance information with large investors as there would be no cost associated with it.

There is also a case for lenient policy to be adopted for high-tech volatile industries. In these industries insiders are very likely to learn information in the course of development activities. The information, such as a new drug discovery, will increase investment and have an overall positive impact conclude the authors.

INSEAD 2002

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