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Insider Trading Essay

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Updated: Aug 12th, 2019

Studies show that stock markets are growing at an alarming rate (Newkirk and Robertson, 1998). For instance, in the US, the stock markets hold twice the amount of money invested in commercial banks (Newkirk and Robertson, 1998). Growth in the stock market is related to the trust and confidence bestowed on it by the people.

In addition, investors believe that financial regulators have a duty to promote and maintain integrity and fairness in the stock market. According to Newkirk and Robertson (1998), successful markets enjoy utmost confidence. However, threats to financial systems such as illegal insider trading might derail further growth in the stock markets.

The debate around insider trading is based on four ethical arguments (O’Hara, 2001).These arguments include asymmetrical information, inequality in accessing information, contravention of property rights and fiduciary duty (O’Hara, 2001). Clark (n.d.) adds that illegal insider trading reduces a trader’s faith in the integrity and fairness of the stock market. In addition, insider trading lowers the efficiency of stock markets and prevents companies from accumulating additional capital. This paper gives an in-depth analysis of insider trading.

Insider trading refers to “transactions in a company’s securities, such as stocks or options, by corporate insiders or their associates based on information originating within the firm that would, once publicly disclosed, affect the prices of such securities” (Dolgopolov, n.d., para. 1). Individuals who are able to access valuable information from such firms are called corporate insiders (Dolgopolov, n.d.).

Examples of corporate insiders include employees, managers and directors of a company. According to the U.S. Securities and Exchange Commission (n.d.), insider trading can be legal or illegal. An illegal insider trading takes place when a stock trader possesses knowledge that can positively or negative affect a company’s stock.

The U.S. Securities and Exchange Commission (n.d.) also reiterates that a person who receives secondary information from a corporate insider is also guilty of illegal insider trading. This exchange of information is referred to as tipping (U.S. Securities and Exchange Commission, n.d.). Nevertheless, legal insider trading takes place frequently in most companies. In this case, a company sets policies and regulations within which its employees or managers can transact in its shares (Newkirk and Robertson, 1998).

“The main ethical arguments against insider trading include asymmetrical information, in-principle access to information, contravention of property rights in information and fiduciary duty” (O’Hara, 2001, p.1). According to the asymmetrical information argument, insider trading is unfair due to the fact that all parties involved in the stock market do not have equal information. For that reason, insider trading does not give all traders a fair playing ground.

Similarly, additional knowledge about a company gives a corporate insider undue advantage over other traders. For instance, corporate insiders are able to avoid loses or generate profit at the expense of other stock traders (Newkirk and Robertson, 1998). In-principle access to information simply means that ordinary share holders are not able to access appropriate and adequate information on certain securities.

Lack of information mostly affects small scale traders. Large corporations are least affected since they are able to access necessary information on stocks. The other argument against insider trading is the contravention of property rights. In this regard, a company’s inside information is treated as a property (O’Hara, 2001). Consequently, any deals involving this information are considered illegal.

The last argument against insider trading maintains that corporate insiders owe a fiduciary duty to shareholders (O’Hara, 2001). For that reason, a company and its officers must act in the best interest of shareholders. When a corporate insider engages in insider trading, he acts purely in his own interests.

Negative impacts of insider trading are far-reaching. Publicly-traded companies get most of their capital from shareholders (Clark, n.d.). Clark (n.d.) reaffirms that money accumulated from the sale of shares is utilized in product research, creation of new business lines and local and overseas expansion. Additionally, a company is kept afloat by shareholders’ equity during lean times. On the other hand, a shareholder is rewarded through dividends and an increase in the worth of his shares.

However, a company and its shareholders may not be able to accrue such benefits if insider trading is encouraged. In most cases, illegal insider trading discourages traders from buying stocks. As a result, most companies are unable to raise money to fund their growth or daily operations. Furthermore, insider trading is detrimental to a market’s liquidity as it increases the cost of transactions (Dolgopolov, n.d.).

The explanation to this argument is that specialized intermediaries lose from trading with corporate insiders. Dolgopolov (n.d.) affirms that special intermediaries provide liquidity to stock markets through frequent buying and selling of shares. Thereafter, these intermediaries “recoup their losses by increasing their bid-ask spread (the differential between buying and selling prices)” (Dolgopolov, n.d., para. 14.).

The scandal involving Enron is a typical example of how insider trading can reduce trust on the stock market (Clark, n.d.). Jeffrey Skilling, the CEO of Enron, conspired with some of the top managers to engage in illegal insider trading. Enron’s share prices were secretly increased by fraudulent accounting practices that inflated its earnings.

However, when the company fortunes dwindled further, Skilling and other executives sold most of their shares. By selling their shares with the knowledge that Enron’s shares were going to drop, Skilling and his accomplices engaged in insider trading. This act discouraged prospective traders from buying Enron’s shares. Consequently, it took the intervention of congress to restore public confidence in Enron’s stock after the Scandal (Clark, n.d.).

Additionally, before the 1990s, there was a common perception that the European markets were infested with insider trading (Clark, n.d.). Similarly, these markets regained their prestige after the European Union forced its members to fight illegal insider trading. These examples clearly indicate that insider trading is more of a foe than a friend to a financial system.

It is unethical for people who are aware of information within a company that is not available to all stock traders to buy or sell its shares. If such people engage in any stock dealings with that company, they are guilty of insider trading. When done on small scale, insider trading disjoints the market and upsets local and international investors (Dolgopolov, n.d.). However, when done on large scale, insider trading erodes the confidence and trust bestowed by traders on the stock markets.

Consequently, potential investors shun the stock markets altogether. In summary, insider trading reduces the efficiency of the markets, makes it difficult for companies to raise capital and erodes investor confidence in the markets (Dolgopolov, n.d.). Insider trading is, therefore, made illegal as it adversely affects the stock market and a firm’s value. Moreover, this is the economic rationale used to discourage insider trading.

References

Clark, J. (n.d.). . Web.

Dolgopolov, S. (n.d.). . Web.

Newkirk, T.C. & Robertson, M.A. (1998). . Web.

O’Hara, P.A. (2001). Insider trading in financial markets: legality, ethics, efficiency. International Journal of Social Economics, 28(10). Web.

U.S. Security and Exchange Commision. (n.d). . Web.

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