What does insider trading entail?
Insider trading occurs when someone purchases or sells a financial asset using market-moving nonpublic knowledge.
As an example, suppose you are an executive at a firm that is considering an acquisition. If it is not publicly available, it is considered inside information. It becomes a criminal when you either tell other people about that as well – and that friend then uses that knowledge to acquire or sell a financial asset – or if you make an agreement yourself.
If convicted of insider trading, the penalty can vary from the few months to more than a decade in prison.
Insider trading became outlawed in the United States in 1934, when Congress established the Securities Exchange Act in response to the world’s worst persistent stock market fall. The stock exchange dropped 89 percent of its value between Black Monday 1929 and the summer of 1932. The measure was intended to prevent the recurrence of a slew of abuses, including insider trading.
The subject was depicted in Oliver Stone’s 1987 classic film “Wall Street,” in which unscrupulous banker Gordon Gekko amasses huge amounts of money by speculating on inside knowledge gained from his apprentice, Bud Fox.
“The most precious commodity I am aware of is knowledge,” states Gekko, who is accused of insider trading and sentenced to prison by the film’s conclusion.
Examples of Legal Insider Trading
While most people associate “insider trading” with unlawful activity, the Securities and Exchange Commission emphasizes that “insider trading” can also be permissible in certain circumstances. Examples of lawful insider trading include the following:
- A corporation’s CEO purchases 1,000 shares of the corporation’s equity. The Securities and Exchange Commission is notified of the transaction.
- A corporation’s employee activates his share options and purchases 500 shares of the firm for which he works.
- A corporation’s board of directors purchases 5,000 shares of the corporation’s equity. The Securities and Exchange Commission is notified of the transaction.
Examples of Illegal Insider Trading
Contrary to popular belief, insider trading is not synonymous with lawful insider trading. A person who participates in unlawful insider trading may or may not work for the firm whose shares he purchases. The critical point is that the individual who purchases or sells the shares does so in violation of the law by acting on insider information (rather than public information).
Several examples include the following:
- A lawyer defending a company’s CEO learns during a clandestine session that the CEO would be indicted the next day for accounting fraud. The attorney shorts shares of the stock of the corporation, anticipating that the share price would plummet in the wake of the indictment.
- A company’s board of directors is aware that a merger is about to be disclosed and that the company’s stock is expected to skyrocket. He purchases 1,000 shares of the company’s stock in his mother’s name in order to profit from his insider information without notifying the Securities and Exchange Commission or making the acquisition public.
- A senior employee overhears a meeting in which the CFO discusses how the firm would be declared bankrupt as a result of serious financial troubles. The employee is aware that his acquaintance owns business stock. The employee advises his friend to sell his stock immediately.
- A government worker is aware that a proposed law is about to be implemented that will benefit an electrical firm greatly. The government employee covertly purchases shares in the electrical firm and then works to expedite the regulation’s passage. Unbeknownst to him, a corporate executive learns about a secret merger between his firm and another rich venture. Recognizing that the merger will need the acquisition of shares at a premium, the corporate executive purchases the shares the day before the merging is scheduled to occur.
These are only a few of the numerous instances of insider trading.
Insider trading is a white collar crime, and those convicted of it face prison time.
Why is it significant
Insider trading is not a crime without victims. By putting sand in the financial markets’ wheels, those who profit from inside information gain at the expense of everyone else.
High liquidity is a critical property of well-functioning financial markets, since it enables massive deals to be executed at low transaction costs. Insider trading impairs market liquidity and increases transaction costs, lowering investor returns. And because a large number of individuals have an interest in the financial markets – almost half of American households own stocks explicitly or implicitly – this conduct is detrimental to the majority of Americans.
Additionally, insider trading increases the cost of corporations issuing stocks and bonds. If investors suspect that insiders are trading a company’s bonds, then will demand a greater rate of return to offset their disadvantage — raising the company’s cost. As a consequence, the firm has less funds to put in expanding its workforce or building a new plant.
Insider trading obviously has larger ramifications. It erodes public faith in money system and reinforces the widespread belief that the chances are stacked against the average person.
Additionally, because inside traders earn from special access to the information rather than labor, this contributes to the perception that the system is corrupt.
Putting an end to insider trading
The likelihood of Congress passing legislation prohibiting legislators from trading stocks increased recently when Speaker Nancy Pelosi indicated she might support the notion – though she would prefer that the prohibition extend to the Supreme Court, which completely lacks any rules governing the practice. At least several Republicans, like Rep. Kevin McCarthy of the United States and Sen. Ben Sasse of Nebraska, have stated their support for a ban.
The Federal Reserve, for its part, responded to the trading by two former officials by prohibiting bank officials and senior employees from purchasing individual stocks and bonds.
There are even less draconian methods of preventing insider trading. In recent years, politicians in the United States and the United Kingdom have tightened the rules controlling economic data release. For example, in the United Kingdom, hundreds of government servants used to get price economic data immediately prior to its public publication. After the practice was discontinued in 2017, we discovered considerably less informed trading prior of the publication — implying that it successfully eliminated a large amount of insider trading.
Surveys indicate significant bipartisan support for Congress prohibiting members from trading financial instruments, with a recent survey indicating 75% approval. While this does not guarantee that a bill will be approved, it does place pressure on politicians from both parties to address the issue.