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Insider Trading Essay

1382 words - 6 pages

There is a long-lasting debate on whether \emph{insider trading (IT)}, defined as trading in possession of material private information, should be allowed or forbidden and, even now, it is not clear what the optimal IT regime might be. IT regulation, and whether this regulation is enforced, differs across countries. For instance, IT laws are lax in Norway, and Mexico and strict in the US and Ireland; however, there have been enforcement cases in Norway and the US, but never neither in Mexico nor in Ireland\footnote{See \cite{Beny:2005} and \cite{FerreiraFernandes:2009}.}. There are differences in what is considered illegal IT between American and European regulations: in the US, under Rule 10b-5, anyone in possession of material inside information shall disclose his private information or abstain from trading\footnote{The origin of this interpretation can be traced to \emph{SEC v. Texas Gulf Sulphur Co}, although latter the Supreme Court limited the liability to the cases in which there is a fiduciary duty of the insider to the persons with whom he trades (\emph{Chiarella v. US}), to tippees (\emph{Dirks v. SEC}), and to the cases in which there is a fiduciary duty of the insider to the source of the information (the so-called misappropriation theory, endorsed by the Supreme Court in \emph{US v. O'Hagan}).}; in Europe, directive 2003/6/EC on insider dealing and market manipulation requires ``inside information'' to be of a ``precise nature", and forbids both, trading in possession of inside information and the disclosure of this information, ``unless such disclosure is made in the normal course of the exercise of his employment, profession or duties".

This debate on the optimal IT regulation is due, in part, to the fact that the welfare consequences of insider trading are still not well understood. For instance, IT could increase market efficiency and be an effective way to compensate corporate agents for innovations\footnote{\cite{Manne:1966}}; on the other hand, IT puts uninformed investors at an informational disadvantage and, therefore, generates an adverse selection problem. It is not clear, from a welfare perspective, whether the benefits of IT compensate for its drawbacks. As a contribution to the debate, I analyze the effect of IT on welfare by means of a model that is suitable for welfare analysis, in which insiders can take actions that directly affect firm's returns\footnote{Given that insider's actions directly affect the production process, she can be seen as a corporate decision maker and I will refer to her as the manager.}, private information has social value, and all market participants behave rationally and understand the structure of the economy. This framework allows me to analyze which is the optimal IT regime among the considered alternatives, and it can be extended to analyze further executive compensation schemes.

One key element of the model proposed here is the presence of two agency problems between the corporate...

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