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Legalize Insider Trading?

Anthony Randazzo
October 26, 2009, 4:59pm

Knowledge processes are a vital aspect to countless industries. The government is generally run inefficiently because of a lack of information available to or known by policy makers. Good businesses are those that understand their customer's needs, wants, and preferences. And when it comes to Wall St., investors live and die by the intelligence that they gather.

This is the complication of the trial of Raj Rajaratnam, a billionaire hedge fund manager accused of insider trading. In reality, his case is more like "outsider" trading, as dubbed in a WSJ column today, in that Rajaratnam and his Galleon Group hedge fund weren't insiders trading based on information they were privy to, but instead were privileged to inside information that others did not have access too. If they are guilty of breaking the law, then they should be punished for that, but the case brings up a valid debate over the necessity or desirability of the particular law. Just what constitutes outsider trading?

Gordon Crovitz opines in The Wall Street Journal this morning:

the Galleon case is about what might be called "outsider trading"—trading by people who gathered information from insiders about company performance or operations, not trading by the insiders themselves.

The reason the U.S. government should tread carefully in criminalizing outsider trading is that markets run on information, analysis and the connecting of dots to determine when prices are too high or too low. Economist Milton Friedman once asserted, "You should want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that."

The thing is that, there are a lot of cases of "outsider" trading. Wall Street daily traders know lots of info that I don't. There is a reason that layman day traders don't always do as well as the professionals—because the pros know things we don't know. Does that make the system unfair? Not any more than it is unfair I can't hit a ball 500 feet like Albert Pujols. Are people smarter and paying more attention to the world than myself outsider traders? I should hope not.

Maybe we should be taking Friedman's advice. This would provide us with some really fascinating, more up-to-date information on the health of companies, and it might force them to be a bit more open and honest, creating a better business atmosphere. Just think if insiders could trade on rumors or special knowledge of their business. If we legalized this practice, they could trade based on that information, communicating a message to us about the health of the firm. My idea would be do legalize this in such a way that you could trade the sale or purchases of a particular company's stock only when announcing yourself as an employee. We could have two indices for stocks: one the aggregate up or down slide of company equity, and the other a tracking of the confidence in a firm by its employees. If Apple's stock trades by employees started to plunge, the rest of us would know quickly that something was amiss, and this would get the company to the press conference table really fast.

This kind of thing is already done on other stuff. The Intrade prediction markets track things like the odds of Obama sending more troops to Afghanistan and when the Boeing 787 will be done. If you work for Boeing, and you catch word that the 787 maiden flight is going to be before the end of the year, you will jump on this chance to make money. It is legal, and it is the point of the prediction markets, bringing knowledge able to the public square and collecting the insider information. Right now the Intrade line on the 787 taking off by the end of December is 45%, which means that even Boeing isn't quite sure yet. But if you see this bet spike then you can bet something good is about to be announced.


Anthony Randazzo is Director of Economic Research


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