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I feel I must first make the confession that I know very little about stocks and trading them. But when I heard the news of Raj Rajaratnam convicted and what he was convicted of (insider trading), it go me to thinking. Why is it considered illegal? Isn't using privileged information when trading stocks akin to having a "secret formula" that you keep from your competitors?

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    Many libertarian economists do not accept that insider trading is harmful, and don't think it should be illegal. Some of them argue, for instance, that the Enron scandal could never have happened had insiders been able to trade on their knowledge on the empty internal dealings of the company's sham investments. I'm not sure what to think, myself; I think one's position on this depends on how much one values the knowledge discovery ability of markets vs. the thought that ordinary people should feel safe and not exploited, so that anyone, rich or poor, might invest prudently for the future. – Uticensis May 13 '11 at 4:22
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    This has been a very interesting and enlightening discussion. I wish I could accept answers from all of you :) – System Down May 13 '11 at 15:59
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    @Billare, write your comment as an answer! – Anthony Mastrean Nov 15 '11 at 20:19
  • This question is better suited to a site like Politics, because there's no real answer other than "because a bunch of legislators decided to make it illegal". – jamesqf Feb 23 at 18:50
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A practical issue is that insider trading transfers wealth from most investors to the few insiders. If this were permitted, non-insiders would rarely make any money, and they'd stop investing. That would then defeat the purpose of the capital markets which is to attract capital.

A moral issue is that managers and operators of a company should act in shareholders' interests. Insider trading directly takes money from other shareholders and transfers it to the insider. It's a nasty conflict of interest (and would allow any CEO of a public company to make ton of money quickly, regardless of their job performance).

In short, shareholders and management should succeed or suffer together, so their interests are as aligned as possible and managers have the proper incentives.

  • Managers and operators of a company should already be obliged by contract to act in shareholders' interests at all times. Why should this particular kind of contractual breach be criminalised, when many other kinds are not? – Robin Green May 12 '11 at 23:06
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    I'd say because there's little ambiguity here - it's a way managers could screw shareholders massively and get rich in the process, and there's no legit reason to be doing it. So I'd say there's a societal interest in the threat of jail time. Financial penalties wouldn't really be effective, see 2008 financial crisis... – Havoc P May 12 '11 at 23:45
  • I think it is even more general: insiders are not only company managers or employees. As far as I know (not being a lawyer) e.g. just overhearing a stock price relevant conversation in a coffee shop without knowing the people and acting on that information would be insider trading. It seems to me to be very generally in place to guarantee the stock market is a fair playing field for everybody (well yes I know, ... this is theory we're talking here). – user3377 May 13 '11 at 5:16
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    "non-insiders would rarely make any money, and they'd stop investing" - exactly; the behaviour of insider trading is similar to the "rent-seeking" behaviour of monopolists or anti-competitive conspiritors. When markets become distorted in this way then investors without these connections stop investing for fear of being ripped off and the entire economy loses to the benefit of the few. – Turukawa May 13 '11 at 8:54
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    @HavocP "would allow any CEO of a public company to make ton of money quickly, regardless of their job performance" Sadly, in many cases that's already true. – Chelonian Jun 29 '12 at 15:54
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@sdg - If you can be flippant, I can be pedantic. Insider Trading is not illegal. Any employee of a company can be an insider, yet most of their trades are perfectly legal. What is illegal is trading on Inside Information. Such information may be available to those within a company, or those who have some contact with an employee. In fact, if I am seated at a restaurant table and hear Bill and Warren talking about a purchase they plan to make, I am in possession of inside information and risk prosecution should I purchase shares and profit. Often, a company will have a "quiet period" before earnings reports or potential stock-price-moving-news. During this time, employees are forbidden from buying or selling shares, excluding those that would be automatically bought in their retirement accounts or ESPP.

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I'm surprised at the tone of the answers to this question!

Trading with insider information is corruption and encourages fraud. As in many areas, there's an ethical line where behavior the gap between "ok" and "illegal" or unethical is thin.

The classic local government insider information example is when the local councilman finds out that a highway exit is being constructed in an area that consists mostly of farmland. Knowing this, he buys out the farmers at what they think is a premium, and turns around for 10x profit a few months later.

In that context, do you think that the councilman acting on that insider information is committing a crime or ethical lapse? Most people say yes.

Even in this case, the line is thin. If the same councilman has his finger on the pulse of growth patterns in the area, and realizes that the terrain makes a certain area a prime candiate for a highway and exit, buying up land would not be criminal -- but it would be risky as it creates a perception that he is abusing his position.

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    Yet oddly, members of congress can trade with inpunity when laws they are about to pass will affect their investments (e.g. the 2008 bailouts) – Michael Jan 16 '15 at 1:35
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To be flippant: it is illegal because it is against the law; there is no considered involved, it just is.

To elaborate, part of the illusion of the stock exchange and other market-like entities is that of (apparent) fairness.

If I think a stock will go up because it is involved in a growing industry, that is generally public information. Conversely if I have a dim view of a particular company because of its track record of product launches, that is similarly out in the open.

A secret formula is something that I invented or discovered, not (presumably) something that I stole from someone else.

To stretch that further: If I notice that Company X stock always moves with Company Y stock, that is indeed something that I have found, that I can try to profit from. It is secret to me, but not particularly dependent upon information not available to others, just that my interpretation is better.

So trading on information in the public domain is fine, as it preserves the principal of fairness I mentioned, whereas inside knowledge breaks that principal.

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    +1. Altho the law is considered: it isn't until someone considers it and makes it so. – Andy Wiesendanger May 12 '11 at 19:45
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Capitalism works best when there is transparency. Your secret formula for wealth in the stocks should be based on a fair and free market, as sdg said, it is your clever interpretation of the facts, not the facts themselves. The keyword is fair.

Secrets are useful for manufacturing or production, which is only a small part of capitalism. Even then we had to devise a system to protect ideas (patents, trademarks and copyrights) because as they succeed in the market, their secrecy goes away quickly.

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Illusions of transparency. Mitigation of risk. Emotion. The system.

Short answer per sdg's post - it's the law.

Long answer which I wont get into - it's a philosophical stance. It makes people feel better. It encourages a sense of "the system really does work."

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"Secret formulas" are legal, "privileged information" is not. And that may be the whole point.

People are allowed to trade stocks profitably if doing so results only from their skill. A "secret formula" (for evaluating information) is part of that skill.

But having "privileged information" is not considered skill. It is considered an unfair, illegal advantage. Because company officials (and others) with privileged information are 1) not permitted to trade stocks while that information is privileged and 2) are not allowed to share that information with others. Inevitably, some do one or the other, which is why they are prosecuted.

"Raj" took the process to new highs (or lows). He not only "dealt" in privileged information, he PAID for it. Anything from a new car or house to $500,000 a year in cash. In essence, he had a bunch of strategically placed "spies" inside or close to corporations including one on the board of Goldman Sachs, "selling out" their companies, and thereby practicing a form of corporate "treason."

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It is illegal because laws are written by people, and laws of stock trade are written, in part, to make it appear "fair" and thus contribute to the willingness of the people to invest their money in that particular venue. Profiting from information on the stock market that some people have and some can't have is considered "unfair", since it presumably excludes the latter from profit-making opportunities and thus makes their trades less profitable than otherwise. Since it is universally felt so, people made laws that prohibit such behavior.

I am not aware of any research that shows beyond doubt that allowing insider trading would really ruin stock markets, but such thing would be very hard to prove. There are arguments to both sides, and the side that supports prohibiting such trade has a clear majority, so it is prohibited.

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Most people are not insiders, so they support laws that pre-empt ways of defrauding them. Insider trading results in insiders making money at the outsiders' expense, as a result it is often banned in democratic countries.

Even an autocratic country has a reason to reduce insider trading. It is not hard to see that there is practically no point to trading as an outsider in a market where insider trading is common active. They would take all your money. The safe thing from you to do is withdraw from that market, and only invest in companies where you are an insider. The result is that most people will not invest in most stocks and there will be a capital shortage. This obviously grinds the economy to a halt - something most governments abhor, as a result they block insider trading to keep everything running smoothly.

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