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Inside Job: Why the Trial of Galleon Founder Raj Rajaratnam Is a (Necessary) Sideshow

The trial of Galleon founder Raj Rajaratnam on charges of insider trading is framed in some quarters as a test of Main Street's sentiment toward Wall Street. Convict the hedge fund billionaire, the story goes, and restore public faith in the financial markets; let him walk and confirm suspicions that the game is rigged.

I don't buy it for a second. Insider trading has a very long and distinguished history in this country. Why would putting Rajatratnam in jail erase old doubts about the investment trade any more than locking up Martha Stewart, Ivan Boesky, or, really going back, William Duer did?

If anything, these cases mainly highlight how the Street wouldn't exist if there was no money to be made from insiderhood -- the outside is for saps, like just about anyone with a 401(k) plan. That hasn't changed in more than 200 years, and there's no reason to assume it's about to change now. As federal prosecutor Ferdinand Pecora said in the 1930s after his landmark investigation into financial fraud, "Wall Street may prove to be not unlike that land, of which it has been said that no country is easier to overrun or hard to subdue."

More dangerous game
The government's prosecution of Rajatratnam isn't so much a line in the sand -- none shall pass! -- as a modest reminder that there are limits, even for rich guys. And it goes without saying that those limits are worth enforcing.

But to state the obvious, Rajaratnam is on trial because he got caught. And he got caught because he appears to have been brazen and arrogant in using tipsters such as Rajat Gupta to feed him privileged corporate information. Although the charges against him represent the biggest insider-trading case ever connected with a hedge fund, the case says relatively little about how hedge funds affect the financial system today.

And on this score the SEC has been far less bold. The agency swung and missed in accusing Goldman Sachs (GS) of consorting with hedge fund baron John Paulson to design self-destructing CDOs. Other Wall Street firms and funds did the same, inflating the housing bubble. Another major hedge fund, Magnetar, also is implicated in far more threatening schemes than Galleon, having pumped up demand for up to 60 percent of the subprime loans that subsequently burst into flames. As financial pundit Yves Smith has written:

Magnetar went into the business of creating subprime CDOs on an unheard of scale. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder.
Short arm of the law
By contrast, Rajaratnam is an amateur. Investors like Magnetar are more dangerous because they grasped something he clearly never did -- that you don't have to break the law to mint money. You just have to stay ahead of it.

What is to be done? Securities regulators want to rein in hedge funds' penchant for taking risks by making them disclose their bonus arrangements with executives. The Dodd-Frank financial reform law also requires larger funds to register with the SEC. Other government watchdogs have proposed forcing funds to provide information about their investment strategies, including how much leverage they use and their credit exposure to other financial players.

Rules aren't fail-safe, of course, as recent insider-trading scandals show. The financial industry is also notoriously clever at "innovating" itself beyond the reach of regulators. Yet when it comes to restoring public confidence in the financial markets, this is where the real is action is -- within the tangled economic incentives that investors have to game a system that is itself an elaborate game.

So shall we place Raj Rajaratnam's head on a spike high above the city walls? If he's guilty, by all means. Fear of prison is a greatly underutilized deterrent to white-collar crime. Just don't expect it to have much effect in curbing insider trading. Spectacle is no substitute for the harder work of cleansing the financial system.

Image from Flickr user Modesto

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