Insider Trading as a Transactional Cost: a Market Microstructure Justification and Optimization of Insider Trading Regulation

Abstract

This Article offers a direct justification for the regulation of insider trading from an economic perspective using the recently developed financial methodology of market microstructure. Insider trading should be understood as a category of informed trading. Informed trad- ing is, generally, desirable because it promotes efficient pricing. However, lack of competition with other informed traders may allow small groups of informed traders to extract more profits than a competitive group of informed traders without influencing prices as much. The profits of informed traders take the form of a transaction cost burdening uninformed trading. Insider trading regulation prohibits the informed trading of traders who have monopolistic power over their information and, thus, results in a reduction of the transaction cost informed trading generates without significantly delaying the correction of prices. By reducing transaction costs, insider trading regulation promotes liquidity. Liquidity, however, also determines how broad the definition of insider trading should be. Inferential support for these conclusions is drawn from regulatory history.