Insider trading is a phenomenon of an imperfect market and arises due to information asymmetry, which means that some market participants have more information than others. This access to additional information can help them gain more profits than other market participants, and defy the principle of equitable trade. The paper attempts to describe the concept insider trading, how it works and the potential problems caused by it. The paper is divided into four sections. The first section describes insider trading. The second section discusses how insider trading works. The third section identifies the problems associated with it and the fourth section concludes the paper.
Concept of Insider Trading
In simple words, taking the advantage of insider information to gain abnormal profits or avoid losses while trading in financial securities, usually stocks, is known as insider trading. The two key characteristics of insider trading that differentiate it from normal trading. First, insider trading involves acting on insider or non-public information. Second, insider trading has the potential to yield abnormal profits, which means that the insider information is material enough to cause changes in the price of a company’s stocks. If the information does not have the potential to cause variation in the price of financial securities, particularly stocks, acting upon it does not amount to insider trading. Thus, trading on material and non-public information is called insider trading (Schwezer Study Program 11).
How does Insider Trading Work
Common law has historically required full disclosure of relevant inside information by an agent, e.g. manager, to a principal, e.g. shareholder (O’Hara 1). Managers by virtue of their position in an organization have access to more information than the shareholders. Taking the example of a pharmaceutical company, research is an indispensible part of such firms. Getting the approval of the designated government authority on a newly discovered and patented drug is big news for a company. It takes years for a company to achieve such breakthroughs. There is obviously a time gap between the time a manager working on this new drug gets to know about this approval and when the information is made public. Once public, this information has the potential to increase the stock price of the company. So, at present, this information is material and non-public and the manager has an incentive to act upon this information for her own financial benefits. This is how insider trading works. However, if the manager acts upon this information, it will be against the shareholders’ rights.
Other avenues of getting access to material and non-public information are by overhearing critical financial information, getting hold of confidential memos and during informal conversation with people possessing such information.
Problems Associated with Insider Trading
The major problem associated with insider trading is that it is illegal in most of the countries. So, indulging in insider trading is against law and a punishable offence. Corporates are required to create firewalls to restrict their employees from getting involved in insider trading. The other problems associated with insider trading are pertaining to ethical considerations and disruption of market principles.
Shareholders own the company and have the first right on company’s profit. Managers and operating executives are responsible for acting in the best interests of the shareholders of the company. By getting involved in insider trading, an executive acts against the best interests and rights of the shareholders, which is not correct ethically. Financial ethics requires avoiding any such malicious practices.
Insider trading disrupts the market principles of fair and equitable trade. By possessing unequal information, parties to the financial transaction are not at equal standing. This one of them is bound to lose from the transaction while the other party gains. This may shatter investor’s confidence in the economy and discourage her to invest in companies. The lack of funds will impact the growth of the company, thereby slowing down economic growth of the nation. Having said that, the problem with insider trading is that it is usually difficult to get caught, which encourages people to commit such crimes. In a survey conducted, 16% people responded that they would be willing to indulge in insider trading if it amounted to huge profits and there was no fear of getting caught (Benoit n.pag.).
Conclusion
Insider trading is acting on material and non-public information. By position, managers have access to more information about a company than the shareholders. Insider trading is illegal in many countries. In addition to this, financial ethics and market principles also restrict such practices. But, though illegal and ethical, it is difficult to catch hold of people who are involved in insider trading. Hence, people have incentive to indulge in such malicious practices if huge money is at stake. To control such incidences, corporate and government need to take preventive actions and create firewalls and effective policies against insider trading. If not contained effectively, insider trading practices may have serious ramifications as it has the potential to adversely affect the economic growth of a nation.
Works Cited
Benoit, David. “Financial Industry Survey: 16% Would Commit Insider Trading”. The Wall Street Journal, 10 Jul. 2012. Web. 25 Jul. 2012.
O’Hara, Phillip Anthony, “Insider Trading in Financial Markets: Legality, Ethics, and Efficiency”. International Journal of Social Economics, 28.10 (2001): 1046-1062. Web. 25 Jul. 2012.
Schwezer Study Program. “CFA Institute Code of Ethics and Standards of Professional Conduct”. CFA Institute (2006): 1-208. Web. 25 Jul. 2012.
