Academic journal article Journal of Corporation Law

Insider Trading: Hayek, Virtual Markets, and the Dog That Did Not Bark

Academic journal article Journal of Corporation Law

Insider Trading: Hayek, Virtual Markets, and the Dog That Did Not Bark

Article excerpt

"How is the betting?"

"Well, that is the curious part of it. You could have got fifteen to one yesterday, but the price has become shorter and shorter, until you can hardly get three to one now."

"Hum!" said Holmes. "Somebody knows something, that is clear!"

. . .

Inspector Gregory: "Is there any other point to which you would wish to draw my attention?"

Holmes: "To the curious incident of the dog in the night-time."

"The dog did nothing in the night-time."

"That was the curious incident," remarked Sherlock Holmes.1


This Article briefly reexamines the great debates on the role of insider trading in the corporate system from the perspectives of efficiency of capital markets, harm to individual investors, and executive compensation. The focus is on the mystery of why trading by all kinds of insiders as well as knowledgeable outsiders was studiously ignored by the business and investment communities before the advent of insider trading regulation. It is hardly conceivable that officers, directors, and controlling shareholders would have remained totally silent in the face of widespread insider trading if they had seen the practice as being harmful to the company, to themselves, or to investors. By analogy with the famous article by Friedrich Hayek, The Use of Knowledge in Society, this Article considers the problem of obtaining necessary information for managers of large corporate enterprises. The suggested analytical framework views the share price, sensitively impacted by informed trading, as a mechanism for timely transmission of valuable information to top managers and large shareholders. Informed trading in the stock market is also compared to "prediction" or "virtual" markets currently used by corporations and policymakers.


It has been almost forty years since the publication of my book, Insider Trading and the Stock Market,2 and the topic still has the ability to engender heated argument as well as seemingly unending efforts at analytical explication.3 I apologize at the outset for continuing the debate, especially since I myself thought that it had about run its course. Nonetheless, the topic refuses to die, and it continues to stimulate new hypotheses, one of which is about to be offered.

This taxing of the intellectual tolerance of critics of insider trading may have a redeeming feature for many. In the process of developing this new idea, I have had to reexamine and substantially modify perhaps the most vigorously criticized claim I made for the positive benefits of unregulated insider trading. That claim was the notion that insider trading can be used as an important component of executive compensation. I hope that I am about to offer a much stronger substitute argument.

Fundamentally, my book made only three basic economic arguments.4 One was that the practice of insider trading did no significant harm to long-term investors. The other two were claims of positive benefits from the practice: one, the compensation argument, and the other, the idea that insider trading contributed importantly to the efficiency of stock market pricing.

By and large the idea that there is no direct harm from the practice has held up very well, especially the point that no real damage is caused to an investor who engages anonymously on an exchange in a trade with an insider on the other side of the transaction. However, one "harm" argument of feasible merit has dominated the academic literature for some time.5 This is the so-called "adverse selection" argument. Basically the argument is that since specialists on the floor of stock exchanges (or other market makers) systematically lose money when insiders are trading, they will expand their bid-ask spread in order to cover this greater cost of doing business. In this fashion, it is argued, they pass along the cost of insiders' trading to all outside investors with whom they deal, the so-called "insider trading tax. …

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