Who Owns Information?

In my work for RealClearMarkets, I've been following the story of the collapse of SAC Capital Advisors, a giant hedge fund that is being brought down just by being indicted for insider trading. The way things work these days is that being formally accused by the SEC is enough to sink a big trading company, because no one wants to do business with a firm while the sword of Damocles is hanging over it.

What struck me about the story, though, is this description of what got SAC and its founder Steve Cohen in trouble.

"When I first met Steve Cohen back in 1999, we were discussing SAC's vaunted trading strategies, the ones that made his hedge fund one of the most successful in the finance world and burnished Cohen's rep as one of the world's best traders.

"I said that based on my reporting—I was working for the Wall Street Journal at the time—Cohen started SAC in 1992 with a technique that wasn't that much different than a day trader: He was trading huge blocks of stock by looking for 'teenies,' or small price increments, that he could magnify into massive returns because of the sheer size of his trades.

"It was the only time Cohen seemed angered during our discussion, as I recall. 'No,' he shot back emphatically, 'we employ real trading strategies around here. We do research.' Cohen went on to explain how his firm, SAC, had transformed itself into something much more than a day-trading sweat shop—it was now, he claimed, essentially the biggest and best information gathering machine in the world.

"That information machine has now been deemed by the U.S. Department of Justice to be a criminal enterprise."

Isn't that a revealing formulation? Information gathering is a criminal enterprise.

That just about sums up the case against insider trading laws, and I was shocked to see that case—which up to now I had only heard from the more radical pro-free-marketers—broached in two mainstream media sources.

At Time, Christopher Matthews asks "Why Is Insider Trading Even Illegal?"

"As Charles Gasparino explains in his new book on insider trading, it's largely coincidental that the fed's recent crackdown on the practice—which includes yesterday's indictment of the hedge fund SAC Capital—is taking place in the wake of the worst economic recession in several generations. But the coincidence does provide opportunity to ponder why—given the fact that insider trading isn't anywhere near as pernicious a crime as some other white collar shenanigans—the government spends so much time and energy trying to stop it."

He goes on to summarize libertarian Doug Bandow's argument against insider trading laws: "By preventing those who know more about a stock from acting on that information, you impede the natural tendency of markets to set a fair price." Matthews then responds with a pragmatist argument in favor of insider trading laws.

"The conclusion that researchers from the Federal Reserve Bank of Atlanta came to when looking at all these effects is that insider trading laws do indeed present a trade off. On one hand, insider trading laws distort the market by making it more difficult for prices to reflect all available information. On the other hand, a developed and modern securities market relies on the participation of different types of investors with different motivations and levels of expertise—and without insider trading laws many of these types of investors would stop participating."

I find this conclusion highly suspect, given Matthews's admission earlier on that "even though insider trading has technically been illegal since the 1930s, regulators have only been enforcing the law with vigor for the past 30 years." Throughout that period, including times when insider trading was legal and when laws against it weren't enforced, public participation in the stock market broadly increased, implying that insider trading played little role in keeping people out of the markets.

But at the end of his piece, Matthews gives the game away by admitting that economic arguments are not the basis for insider trading laws.

"For better or worse, Congress doesn't set policy by soberly analyzing economic models. Often its actions simply reflect the emotional will of the American people. And Americans like fair play. With this in mind, it's easy to see why insider trading rules contain some of the contradictions Bandow emphasizes, and why we often see them most strictly enforced during times of financial excess—even when that excess isn't a result of insider trading."

So the real case for insider trading laws is that throwing slick Wall Street traders in jail makes us feel better.

At the Washington Post, Dylan Matthews takes the case against insider trading laws more seriously.

"That's the problem with insider trading bans. They are justified as providing an even playing field for small investors, but obviously such a playing field doesn't exist. You really don't stand as good of a shot of beating the market as a guy with an E-Trade account as you do when you're, say, Steve Cohen. So you shouldn't try. Making insider trading legal would make it clearer to individual investors that picking and choosing stocks is a sucker's game, and deter more of them from trying, to their financial benefit.

"Keeping it banned creates an illusion of fairness that leaves everyone worse off....

"But that understates the case. Insider trading is actually an active good. Markets work best when goods are priced accurately, which in the context of stocks means that firms' stock prices should accurately reflect their strengths and weaknesses."

Note, however, how all of these arguments are still based on a pragmatist assumption that it is government's role to manage everything centrally from Washington, DC, with Congress and the SEC deciding whom to encourage and discourage from entering the stock market, and that it's just a matter of what works better pragmatically.

But if it's bad to throw people in jail just to make you feel better, is it any better to throw them in jail based on a cost-benefit analysis of their utility to society? If we're going to do that, how about if we send a government inspector to assess whether that little economics column of yours has sufficient utility to society?

You can see why we don't want to go down that road. Rather than imposing a lot of government regulations and throwing people in jail based on somebody's calculation of what's best for society, we should create a presumption that the individual is free to act, without fear of going to jail, so long as he respects the basic, clearly delineated freedoms of others. The name we give this idea is: individual rights.

So instead of approaching this question by asking whether the Steve Cohens of the world should be sacrificed to somebody's theory about what is most useful to society, we should approach insider trading by asking: whose rights are involved?

A good way to start is by asking: who owns information about the markets? The premise behind insider trading laws is: the government owns all information. Which, come to think of it, is also the premise behind the NSA wiretapping everyone is worked up about. So if the government owns all information, it gets to decide who is entitled to make use of how much of it.

Bu instead of declaring the nationalization of economic information, let's acknowledge that private companies own their own confidential information. The owners of those companies have a right to decide how their employees use this information, and they can ban or allow insider trading as they see fit—as can the markets which agree to trade their stocks. In this case, insider trading would become mostly a civil matter, a breach of contract with specified penalties. Or for more egregious cases, in which an employee deliberately lies for the purpose of gaining information he can trade on, it might be prosecuted as fraud. But the crime wouldn't be insider trading as such; it would be lying to obtain confidential information.

What about the individual investor who is the "victim" because he doesn't have inside information? Well, he is voluntarily participating in the market while knowing its rules—and he knows, or should know, that no one in the market ever has exactly as much information as everyone else. To assert a right to perfectly equal information is to assert a right to other people's information—information that belongs to them, not him. Information is an economic good, and demanding redistribution of information is no more just than demanding redistribution of wealth.

The strictly economic argument against insider trading—as opposed to the envy-driven emotional one—is that insider trading scares individual investors out of the market, making less capital available and therefore making capital more expensive to raise. The economic argument in favor of allowing insider trading is that it brings information to the market more quickly, by way of the buying and selling of company insiders. What strikes me about both of these arguments is that these costs and benefits are not merely anonymous and collective; they are costs and benefits for corporations seeking capital and for markets seeking a greater volume of trade. So why not put these competing claims to the test in the marketplace? If insider trading raises the cost of capital so much, then companies that forbid it to their employees, and exchanges who forbid it to the traders who participate in them, will benefit from cheaper and more plentiful capital. If insider trading is good for the markets, then those companies and exchanges that allow it will experience the benefits of more accurate pricing.

If, as I tend to suspect, both effects are generally pretty marginal and tend to cancel each other out, then maybe everyone will decide that draconian rules against insider trading don't justify the trouble of enforcing them.

This certainly sounds better than the current system, in which building an "information gathering machine" puts a target on your back.

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