An outlaw story

We all like a good outlaw story, whether a western bandit, a gangster or a spy.  Fortunately, in finance, we also have outlaws.  One guise of them is insider traders.

Unfortunately, most of them are neither very likeable, neither very flashy.  The exception being Ivan Boesky who did it in a big way in the 80’s and, through his association with junk-bond king Michael Milken, brought down the mighty Drexel Burnham Lambert (Read the story in  The Predator’s Ball in the History of Finance section of my bookstore).

The Business Insider website has now published an entertaining summary of the eleven most shocking insider trading scandals of the last 25 years (Read on at : www.businessinsider.com/biggest-insider-trading-scandals-2010-11#1986-ivan-boesky-dennis-levine-and-the-fall-of-drexel-burnham-lambert-1) and Stéphane Wuille, journalist and blogger at L’Echo has added a Belgian version of it (Read on at : blogs.lecho.be/lescracks/2010/11/les-délits-dinitiés-les-plus-choquants-de-belgique.html ).

But insider trading, which is trading on the basis of non-public information, is a victimless offense, isn’t it ?  It should even contribute to market efficiency by incorporating non-public information in the price formation. So why is it punishable ?

Insider trading regulation is a rather recent worry as shown in the graph below :

BD_The_world price of insider trading_044

Source : “The World Price of Insider Trading” by Utpal Bhattacharya and Hazem Daouk in the Journal of Finance, Vol. LVII, No. 1 (Feb. 2002)

Actually, insider trading is not victimless.  It penalizes all the other market participants.  How would you feel trading in the stock market if you knew (or suspected) that your counterparties have (or may have) inside information ?  You would fear to be the patsy, you would partly withdraw from the market, you would have less confidence : in other words, you would increase your required risk premium.  So, here is the victim : the cost of capital. By undermining the confidence of market participants, insider trading decreases the liquidity, increases the risk premium and the cost of capital and therefore decreases the value of assets.  By increasing the cost of capital, it could even deter investment and decrease the growth rate of the economy.  Enough to make it punishable, it sounds !

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