Galleon hedge fund founder, Raj Rajaratnam, has been in the news lately for operating a ring of hi-tech corporate insiders and analysts who willingly divulged nonpublic information, which in turn allowed Galleon to reap less-risk, mo'-money profits. In his case, the moniker "hedge fund" was used to describe a hedge against the efficient-market hypothesis by obtaining illegal information to consistently outperform the broader market through "sure bets."
There are a number of academics and pundits who believe that Rajaratnam's transgressions are in fact helpful to the markets; after all, it was he who first provided information that brought prices into equilibrium. Besides, he really wasn't an "insider," but an outsider who got insiders to talk freely by, in some cases, paying them tens of thousands of dollars. Of course, he made $8 million short-selling Google from this information, among many other prescient trades.
The Securities and Exchange Commission defines illegal insider trading as the "buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security." It seems that they are behind the times, outmoded, and anachronistic; they actually believe that insider trading "undermines investor confidence in the fairness and integrity of the securities markets." The SEC seems to be enamored with this thing called risk; they think that if risk is equally distributed, then the markets will operate as they should. But more advanced minds disagree, saying that if everyone traded on nonpublic information, then our markets would be absolutely lighting-fast and efficient. Or perhaps we wouldn't have markets at all because very few will buy shares for which a select few are guaranteed a risk-free profit.
Rajaratnam's public service by trading in advance of released news should be examined - perhaps we should all sell out our fiduciary responsibility in order to provide the fastest possible correction in the markets. Just imagine, every insider from every public company selling materially significant news to outsiders whose role is to provide rapid price equilibrium. But if the company is not making fraudulent representations of its financial performance, does it matter how quickly the news is acted upon? If everyone has the same information, a price correction that occurs next Tuesday will have exactly the same effect as one occurring this afternoon. Sure, someone could buy an equity 10 minutes before a catastrophic free fall, but they could also purchase 10 seconds before a huge uptick. Armed with identical information, everyone has a equal risk, the definition of a level playing field. Here's the difference: unless they're a small-time player, anyone acting with insider information will telegraph news through their large long-buy or short-sell orders. The market will then react to this risk-free adventurer with the timidity of having news in advance of its official release, dramatically increasing the buy or sell orders that would have occurred under normal circumstances, which then increase the volatility of the price swings.
In effect, insider trading increases beta for everyone but the insider, whose beta is almost zero.
The reason why we have so many commerce regulations is because most businesses want to manipulate risk, and many executives will do anything to lower their risk profile. Unfortunately for society, risk is a zero-sum game; when a single entity lowers their beta through illegal means, the risk goes up for everyone else.
Personally, I believe that insider trading should be treated the same way that old-school Las Vegas casinos handled card cheats, loaded dice, and rigged slots. If you've seen the movie "Casino," you'll know that the lucky ones got the hammer.
