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Why Insider Trading is Here to Stay

How significant is it that New York legals officials are blowing the lid off what appears to be a massive case of insider trading? It depends on how far back your memory goes.

Daily Finance's Peter Cohan says it's big news:

[T]he coming weeks could yield some stunning revelations about widespread insider trading. This does nothing to boost the public's confidence that their retirement money is in good hands.
Indeed, the busts have already started. The FBI this morning raided hedge funds Diamondback Capital, Level Global Investors and Loch Capital. The probe is likely to reel in other funds:
"The FBI is executing court-authorized search warrants in an ongoing investigation," said Richard Kolko, an FBI spokesman, who declined to comment further.
Certainly it's heartening that Manhattan U.S. Attorney Preet Bharara and the feds are tightening the noose on a range of Wall Street traders, analysts and other execs alleged to have gamed the market by paying current and former corporate insiders for material non-public information.

As corporate law professor Stephen Bainbridge notes, insider trading amounts to theft, usually of information. And while there's debate over to what extent that harms the efficiency of the markets (Milton Friedman and other free market fundamentalists would say it actually boosts efficiency), Cohan is correct in saying it undermines investor confidence that trading is fair and transparent.

Insider trading is also widespread. And not only on Wall Street, as Bharara pointed out in addressing the New York City Bar Association last month:

Unfortunately, from what I can see from my vantage point as the U.S. Attorney here, illegal insider trading is rampant and may even be on the rise. And the people who are cheating the system include bad actors not only at Wall Street firms, but also at Main Street companies.

To anyone with a historical perspective on the markets, however, these revelations are far from "stunning." Rather, they're but one more cautionary tale in an unbroken story of predatory trading going back centuries:
It has more than once been foretold that Stock Jobbers and Brokers wou'd Ruine the Trade, and feveral times they have bid fair for the Performance.

But never was a greater Wound given to the Trade in General, than now.... [N]ot never was there fo much Bare fac'd Villainy acted in the Affairs of Public Trade as their is now.

That was author Daniel Defoe -- circa 1701 -- in his pamphlet warning about the risks of market manipulation. It was excellently titled "The villainy of stock-jobbers detected, and the causes of the late run upon the bank and bankers discovered and considered."

In the U.S., 19th century politicos, financiers and other miscellaneous rogues pulled every trick in the book to gain an edge, including cornering the stock of the Second Bank of the United States in the 1830s. Stocks were touted. Pump-and-dump artists fed information to newspapers. Dubious techniques such as "wash sales" were used to trigger and profit from stock swings.

You can follow such malfeasance like a trail of bread crumbs from the hazy past through more recent capers, from Ivan Boesky, Michael Milken and the Enron crooks right into the present era.

So to be "stunned" about these latest reports of insider trading is to be naive about how financial markets really work. Ever notice those sudden, large swings in stock prices at the end of the trading day? These aren't the result of retail investors rebalancing their portfolios -- they're high-frequency traders placing giant orders based on info you won't find on CNBC. Illegal? Who knows. But suspicious enough to make me nervous about my retirement money, as Cohan might have it.

Perhaps most interesting about the latest schemes is that they center on so-called expert networks, in which hedge funds pay corporate or industry insiders for info about a given company or sector. ZeroHedge defines these groups as "legalized insider trading rings for the uber-wealthy, operating largely unsupervised, and leaking selective information to preferred clients."

The line between information that can legally be shared and what is protected under securities law has always been murky. Still, that line exists -- it should be protected, especially as new technologies make it increasingly difficult to tell when the law has been broken. Said Bharara in his speech:

[T]he sheer volume and complexity of modern stock trading heightens the difficulty of pinpointing specific illicit trades that were based on illegally acquired inside information.

When an institution or a trader can jump in and out of positions at the speed of light and in enormous volumes, illicit trades become easier to mask, harder to find, and subject to plausible deniability.

As legal authorities try to crack down on insider trading, in other words, it's finding new networks to traverse. Looking for mischief on Wall Street? Try Facebook, LinkedIn and Twitter. It's hidden there among the myriad newsletters, blog posts, RSS feeds and other digital byways of the modern age, not to mention countless emails and instant messages. That, in turn, makes it easier for people who engage in insider trading to claim that they came upon the info through diligent research rather than by, say, offering a bribe.

So kudos to the legal authorities for taking a stand against such activities. But as for stamping out this "bare fac'd villainy," forget it.

Thumbnail frrom Flickr user Florian1980; interior image from