Insider Trading and Dynamic Informational Efficiency

Why is insider trading illegal? There has been considerable debate within academia over the costs and benefits to society of insider trading. Previous work looks at whether traders are made better or worse off by insider trading but ignores others that are affected. Many look to asset prices for information before making real economic decisions. Those who use prices for information have not been closely examined in the literature. While it is clear they would prefer prices be more informative rather than less, it isn’t clear their preference over the dynamics of market learning or what policies a regulator can implement to maximize their welfare.

Consider how insider trading regulation affects market price learning. Without insider trading, prices gradually come to account for the collective information of countless traders. Prices are constantly moving by small amounts to incorporate information from trades. With insider trading there is a crowding out effect as analysts and other outsiders no longer find it profitable to compete. This effect leads to relatively infrequent trading and price movements, but when trades happen they contain more information on average and lead to larger price movements. Not only the amount of information revealed in prices but also the dynamics of the learning process are important.

Stock prices play an critical role of aggregating and conveying information. There are many economic players that look at stock prices to make decisions other than investing in the stock (managers, regulators, banks, etc.). The debate on insider trading is lacking a serious study of these decision makers that watch stock prices to gather information. Naturally, these decision makers would prefer prices to convey more information rather than less, but do they care about how this information is learned? What sort of price process would these players most benefit to learn from? My project will explore when these decision makers would prefer infrequent sudden market learning caused by insider trading or continual gradual learning caused by outsiders.

In the short run, this project will generate at least one paper to be published in a top international journal in the fields of economics or finance as well as several presentations at conferences and seminars. In the longer run this project will help inform policy makers about the optimal regulation of insider trading, and the ideas of this project will be further explored by others seeking to understand the full impact of insider trading.