One cannot truly appreciate the whole picture without looking at the different angles of that picture. In the same way, one cannot truly comprehend the insider trading debate without studying its effects on the aggregate economy and on the individual actors that are involved therein. In previous articles I have discussed the arguments for and against legalizing or prohibiting insider trading. Different theories have been asserted by the rival schools of thought. Economic models have also been presented by each side to show the effect of a legal or illegal insider trading to the aggregate economy. In this article I would discuss the varying economic models that have been demonstrated to explain the effect of insider trading to the general welfare of the individual actors in the stock market.
The welfare effects of insider trading to the four actors I have discussed earlier, which are the insiders, investors, market professionals and liquidity traders, will be identified through the use of economic models by different scholars. These economic models will also be guides in balancing the costs and benefits of insider trading in each category.
Although economists have different views about insider trading, most of them agree that informed buying and selling of stocks, whether it be insider trading or otherwise, is detrimental to liquidity traders as liquidity traders are at a disadvantage in terms of the information they possess. It must be remembered that liquidity traders trade in the short term and that they trade in order to hedge their positions and balance their portfolios. Economists that agree on this view are Manove, Fishman and Hagerty, Noe and Leland. Shin has a different but related take on the effect of insider trading to the liquidity traders. According to Shin, both the market professionals and the insiders benefit from the information advantage at the expense of liquidity traders. Both the insiders and market professionals gain in information imbalance. Shin believes that if insider trading is partially legalized, the competition for the information between insider and market professionals would to limit the trade losses of the liquidity traders. This scenario not only benefits the liquidity traders but also makes information revelation faster.
Other economic models show, however, that legalizing insider trading would be disadvantageous to the market professional. As explained in previous economic models, in the information advantage competition, insiders always get the upper hand because they acquire the important information at no cost. Market professionals, by being non-insiders, have to use resources to obtain the information. By legalizing insider trading, market professionals would be greatly disadvantaged by the insiders. Even if market professionals would earn from the trade, these earning would be curbed due to the time, money and effort that are spent in getting the much needed information. Some scholars even believe that the situation between insiders and market professionals are so disproportionate that in the long run, market professionals would be forced to drop off the competition and stop trading at all.