I was thinking the other day about the purpose of financial markets and the purpose of financial markets regulation, and I got to wondering why on earth it is that we have a ban on insider trading. After all, one important function of financial markets is supposed to aggregate information so as to price assets correctly and thus guide the allocation of investment. Excluding informed participants from trading subverts the main goal of financial markets’ existence.
What you hear is that these rules are in place to protect investors from getting ripped off. But I don’t think this really stands up to scrutiny. That makes it sound as if the purpose of the stock market is to create an entertaining casino that people want to participate in, thus letting the house get a bigger rake. And of course it’s true that if that were the purpose of the stock market you would want rules against insider trading. But that’s not the purpose of the stock market—at least not the legitimate purpose. After all, simply making insider trading illegal doesn’t mean it doesn’t happen. Stealing cars is illegal, but cars still get stolen. In the case of cars, just telling people to never drive would have an extreme price, but simply warning individual investors that trying to pick stocks is likely to end up with them getting ripped off would be excellent advice. Indeed, even with the ban in place individual investors should know that trying to pick stocks is likely to end up with them getting ripped off.
I looked around on this and found that Fama & French believe in the insider trading ban. Frankly, when you find a regulation that business-friendly academics who never want to regulate anything like, I’m even more inclined to believe that this is a worse idea than it sounds. Basically it’s a government seal of approval on stock market speculation, when the government should not offer any such seal.