insider trading: two comments

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CFA Institute Insider Trading: Two Comments Author(s): Jack L. Treynor and Dean LeBaron Source: Financial Analysts Journal, Vol. 60, No. 3 (May - Jun., 2004), pp. 10+12 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4480567 . Accessed: 12/06/2014 21:34 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. . CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial Analysts Journal. http://www.jstor.org This content downloaded from 185.2.32.49 on Thu, 12 Jun 2014 21:34:15 PM All use subject to JSTOR Terms and Conditions

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Page 1: Insider Trading: Two Comments

CFA Institute

Insider Trading: Two CommentsAuthor(s): Jack L. Treynor and Dean LeBaronSource: Financial Analysts Journal, Vol. 60, No. 3 (May - Jun., 2004), pp. 10+12Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4480567 .

Accessed: 12/06/2014 21:34

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial AnalystsJournal.

http://www.jstor.org

This content downloaded from 185.2.32.49 on Thu, 12 Jun 2014 21:34:15 PMAll use subject to JSTOR Terms and Conditions

Page 2: Insider Trading: Two Comments

PERSPECTIVES

Insider Trading: Two Comments

Jack L. Treynor In making investment decisions, we rarely buy unless we see possibilities in a company that aren't yet in the price; we rarely sell unless we have concerns that aren't in the price. We would like to be the owner when good things happen to a stock and to avoid being the owner when bad things happen. But, of course, when we buy, we deprive the previous owners of the benefit from the good things; when we sell, we defer to the new owner the damage from the bad things.

If we assume the previous owner (when we buy) or the subsequent owner (when we sell) is as motivated as we are, then that owner's motive represents a cost we bear only when we trade-i.e., a cost of trading. We might like to eliminate the other person's trading motive by passing laws against acting on that motive. But we don't, because then we'd make our trading motives illegal also.

So, what's the purpose of insider trading laws? The key is the dealer's role as an intermediary between buyer and seller. The buyer's motive hurts the seller, and the seller's motive hurts the buyer-unless one motive or the other gets into the consensus price between the dealer's first transac- tion and the dealer's second transaction. From the dealer's perspective, "inside" information is infor- mation so unambiguous in its implications, so authoritative in its source, that it gets into the security's price too quickly.

Therefore, laws against acting on inside infor- mation have two purposes: (1) to protect dealers and (2) to give investors the confidence that they are protected from people who know more than they do. If dealers play an essential role in making securities markets liquid, capitalist societies have a stake in protecting dealers. If people who feel protected from insiders are more likely to invest, capitalist societies have a reason for providing that confidence.

So, capitalist societies are probably healthier with insider trading laws. But those laws don't protect the little guy. Instead, they protect some rich, powerful big guys-dealers.

Dean LeBaron Imagine a classroom filled with students-some smart, others not, most in between-who are about to take a test. A few of the students are fortunate; they come from privileged economic or social back- grounds that provide them with an advantage in answering the test questions. And a few are unfor- tunate; their underprivileged economic or social backgrounds are a disadvantage to them. To deal with this disparity, the teacher decides that the advantaged students should stay home on test day.

Is that decision wise? If one purpose of the test is to discover who is bright and who is not, plus measure collective skills of the group, does exclud- ing these students skew the results? I think so.

This analogy fits the rules that exclude insid- ers from trading except at specified intervals, presumably because they know more than less- informed market participants. If one of the pri- mary jobs of markets is price discovery-accurate price discovery-this exclusion makes no sense. By eliminating insiders, we make markets less informed. Market prices no longer reflect the com- bined knowledge of all participants. We push prices in the direction that less well informed investors would take them. And we may increase volatility from uncertainty.

I favor encouraging insider trading at all times. However, I would require insiders to identify their market orders so that the rest of us can judge, without knowing the details underpinning the actions, whether the trading contains information.

What about protecting dealers? The little anec- dotal information I have on dealer returns suggests that this group doesn't need legislative protection. In my classroom analogy, dealers would be equiv- alent to professional test takers. You could hire them to answer test questions as you would answer them, and they would make no administrative mis- takes, such as not using a No. 2 pencil. Not every- one could afford to hire these professionals, and they would add a cost burden, of course, in the market. But they are not adding liquidity; most test takers would not need their services. And dealers

(LEBARON CONTINUED ON PAGE 12)

Jack L. Treynor is president of Treynor Capital Management, Inc., Palos Verdes Estates, California.

Dean LeBaron, CFA, is president of Virtualquest, New London, New Hampshire.

10 ?2004, AIMR?

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Page 3: Insider Trading: Two Comments

Financial Analysts Journal

(LEBARON CONTINUED FROM PAGE 10)

are not providing real liquidity, only a temporary accommodation between buyers and sellers. Most market participants don't need that service. More- over, most examples of the cost of the service sug- gest that it is uneconomical and could be replaced with other (electronic) systems.

I'm not sure that prohibitions against insider trading have much to do with dealer margins, but anything that contributes to market inefficiency, such as insider trading rules, increases the oppor- tunity for higher dealer margins.

Jack is correct in concluding that insider trading is harmful to markets and most market participants. And the point that dealers are helped indirectly by insider trading rules is correct. Among the dealers'

other advantages are their inside knowledge of trading patterns, at least on the NYSE.

I conclude that because insider trading helps price discovery, we should encourage insiders to be active market participants. But how can we do so? First, we should allow insiders to trade all the time with only the requirement that their inten- tions for trading be flagged as potentially privi- leged. Second, companies should make continuous public markets-for example, as a specialist func- tion with an open book and in continuous registra- tion for capital raising or share buybacks. Companies should be the most informed insiders and should continuously reveal their pricing ideas by market behavior.

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