what is insider trading and why is it illegal
what is insider trading and why is it illegal Insider trading occurs when someone – the ‘insider’ – uses information that has not been made public yet to trade a company’s stock or other securities, such as bonds and stock options. This insider can be anyone from a major shareholder to a CEO or company director. Insider trading is illegal because a corporate insider is supposed to represent the interests of the shareholders as opposed to his own interests.
The corporation’s officers are supposed to act in the best interest of the company’s shareholders. So, trust is implicit and indispensable in this arrangement between a company and its investors. Insider trading is a betrayal of that trust. In cases of insider trading, by acting on the information that shareholders aren’t privy to, the officers of a corporation act purely in their own best interests to rake in personal financial gains. When entire markets are widely perceived to be tainted by insider trading, average people who are also potential investors would avoid markets altogether.
An uninformed market is not a fair market, as it may not represent the true value of the securities. The end detriment is to the general public who are indirectly affected through their commitments to superannuation funds and the like. It can be said that if a market is seen as being ‘unfair’ then both the confidence of the players and the credibility of the market are harmed. The regulators commonly observe that the company itself is harmed by insider trading because it becomes difficult for the company to raise capital. The company is harmed by the misuse of information which belongs to it. A more general explanation is that the vast majority of shareholders suffer. They miss out on value where they should have been able to share profits. A somewhat different assessment of the damage is that there is more money lost by people acting on what they think is inside information than by those who sold. The impact of illegal insider trading is considered negative for both the small investors and for the markets. Insider trading makes fair play impossible, and there is no fair demand and supply of stocks, all detrimental to the functioning of a healthy capital market. Insider trading weakens the faith of investors in the investing system and an unchecked insider trading could keep off people from investing capital and this could potentially harm the economy as a whole.
Insider trading is a practice that the market can very well do without. Insider trading harms the market in a number of ways. It is said to erode confidence; to inhibit the capital raising process and to damage the efficiency of the market. The view of insider trading as a victimless crime ignores the fact that in an insider trading transaction there is a party who loses value from the securities involved or is forced to take a loss. Perhaps it might be more accurate to say that insider trading is a crime with an unknowing victim.
Insider trading appears unfair, especially to speculators outside a company who face difficult competition in the form of inside traders. Individual speculators and fund managers alike face inferior returns when markets are more efficient owing to the actions of inside traders. This does not, in itself, imply that insider trading is harmful. Insider trading clearly hurts individual and institutional speculators, but the interests of the economy and the interests of these professional traders are not congruent. Indeed, inside traders competing with professional traders are not unlike foreign goods competing on the domestic market — the economy at large benefits even though one class of economic agents suffer.