Insider Trading
TLDR: Insider trading can reduce volatility and improve efficiency. Banning it is arbitrary and can foster corruption. Utopian markets are less regulated, emphasizing index funds, contracts, and careful research.
Prerequisites: Fairness and Licensure are the two main Utopian Dreams essays that seem useful, though I reference a smattering of others in the Utopia section at the end. Basic financial literacy will also help a lot, especially regarding adverse selection.
Imagine you’re a software engineer at a promising tech startup, grabbing lunch in the company cafeteria. You overhear someone casually mention that a major acquisition deal, previously thought dead, is suddenly back on track and likely closing next week. Excited about the company's prospects, you use your brokerage app later that day to buy a thousand additional company shares, complementing what you’re getting as part of your standard compensation package.
But, whether you realized it or not, buying those shares was illegal. And not just parked-in-the-wrong-spot illegal, but a serious felony offense. “Trading on material, non-public information,” more commonly known as “insider trading,” can be punished with twenty years in federal prison and as much as five million dollars in fines (for individuals). And even when prosecutors decline to press criminal charges, the Securities and Exchange Commission (SEC) can still sue in civil court, demanding up to three times what the trade made in profit.
These risks aren’t just theory. In January of 2025, a Los Angeles engineer earned himself two years behind bars after making a half-million dollars off of a friend’s merger tip. And the year before, a man in Texas was charged for trading based on information that he overheard from his wife (without her knowledge), while she was taking work calls at home. Each year, the US federal government prosecutes approximately 36 cases like these.
At its core, the effort to prohibit insider trading is about encouraging investment and promoting fairness. If some people, especially wealthy executives, have access to more information than outsiders, they can exploit that advantage for profit. A strict libertarian might describe this as “selling the information” but most people see it as harmful exploitation.
The modern concept began to take shape in the United States following the market crash of 1929. While early common law cases like Strong v. Repide (1909)1 touched on the fiduciary duty of insiders, the Securities Exchange Act of 1934 was the landmark legislation. It created the Securities and Exchange Commission (SEC) and gave it broad authority to regulate securities markets, including prohibiting “manipulative and deceptive practices.” Initially, enforcement was relatively limited, but the reach of the SEC slowly grew, especially in the 1960s,2 to restrict and control a broad range of activities within the stock market.
Restrictions on insider trading are not specific to America, however. Every major financial market in the world has similar restrictions. The near-global consensus is that this behavior is clearly detrimental and needs to be illegal.3
Why Insider Trading is Banned
Why is trading on private information considered so harmful? The typical arguments usually include:
Reduced Market Liquidity: If market makers (the entities facilitating trades) suspect they might often be trading against insiders with superior information, they face adverse selection. To protect themselves, they will widen the gap between the prices at which they buy and sell (the bid-ask spread). This makes trading more expensive4 and can reduce overall market liquidity (the quantity of available trades).
Unfairness and Erosion of Trust: The perception that the market is rigged in favor of insiders discourages participation by ordinary investors. If outsiders feel they're constantly playing against loaded dice, they might take their capital elsewhere, such as speculating on land, thereby reducing investment in wealth-creating industry.
Encouraging Manipulation: Allowing insiders to trade freely can create perverse incentives. Executives could potentially manipulate corporate events or disclosures to profit from subsequent stock price movements, rather than focusing on increasing long-term company value. They might even short their own company's stock before intentionally tanking a deal. Politicians and regulators could likewise trade based on confidential policy information.
These concerns are serious. A market rife with manipulation and exploitation will repel investors (and hurt those who are too foolish to stay away), ultimately stifling growth. Is it any wonder that basically every nation has fought to keep insider trading to a minimum?
Why Insider Trading Might Be Good
Considering the near-global ban on insider trading, it might be surprising to learn that not all economists are against it. The most notable of these was Henry Manne, whose 1966 book Insider Trading and the Stock Market argues that this kind of market regulation is ultimately wrongheaded. Let’s consider his ideas, and other arguments in favor of allowing insider trading:
Enforcement is spotty, and leads to potential corruption.
It’s impossible to know exactly how much insider trading occurs, but it’s potentially quite a lot. Subtle forms surely happen all the time, where those who are able to see more than just public documents have small edges. But there are even cases that are somewhat blatant, such as the surge of trading (mostly shorting-selling and later buying options) that preceded President Trump’s tariff announcements at the beginning of April.
Time will tell whether any particular instance of insider trading gets punished, but the spotty enforcement and connection to the government means our current system is already heavily burdened by insider trading and opportunities for corruption. Any narrative that claims insider trading would ruin the market needs to account for the fact that the market continues to function despite the presence of some insider trading that we see currently.
Deregulated trading means more accurate prices and faster updates.
Accurate prices are the foundation of efficient allocation of capital. If a company’s true value is different from its market price, such as due to a secret, investors may make foolish decisions as a result. An example of this might be a tech company hiding their losses on their new product in order to keep their stock price high, but as a result their competitors believe it to be more profitable than it is and waste effort replicating a dud.
Society usually tries to encourage accuracy and speed by mandating that companies publicly disclose important information (such as profits) without delay. These laws come with their own costs, such as potential competitive disadvantage with privately traded firms.
When insiders are allowed to trade, they predictably push stock prices towards their true values faster and more reliably than official press releases. For instance, as a business deal gets closer and closer to being made, the price of those stocks can gradually shift, instead of suddenly moving only after the deal goes through and is announced on the news.
Day trading is mostly a waste. Market volatility is bad.
Even though accurate prices are important, I would argue that we, as a society, invest too much time and talent into tracking them. The significant majority of market activity (~85% perhaps) is uninformed trading based on little more than vibes, rumors, or fleeting sentiment — essentially “noise.”
Immense resources and intellectual talent are poured into predicting the foolish wanderings of uninformed traders. And while theoretically helpful for keeping the prices closer to their true values, this broad pattern is mostly a zero-sum game.
If there were stronger warnings against uninformed trading, such as the “unfair” playing field of insiders vs outsiders, there would probably be less volatility and thus fewer incentives for brilliant people to spend their careers trying to understand that randomness.
Insider trading is a natural reward for whistleblowers.
Telling the public about the misconduct of your employer can be a very scary prospect. Whistleblowers can face severe retaliation, including job loss, demotion, costly legal battles, harassment, and industry blacklisting, making it difficult to find future employment. The risk of these substantial costs can understandably silence many who witness wrongdoing, even if they would otherwise feel a moral duty to speak up.
If an employee can legally short a company’s stock (and/or selling the tip to a wealthy capitalist) before blowing the whistle, they’d have a powerful financial incentive to do so. This incentive would both soften the natural costs on the whistleblower, and encourage them to speak up where they might otherwise see no reason to act.
Contracts can still prevent abuse.
Legalizing insider trading doesn't mean normalizing all behavior. To prevent executives from deliberately trashing their firms, companies could ban certain forms of insider trading on a contractual level, similar to how IPOs are handled. Likewise, policy makers could be similarly bound by contract with their government not to exploit their position to manipulate policy for their own gain. The blunt tool of a blanket statutory ban could then be replaced by more nuanced, bespoke agreements.
Laws should be crisp and clear, for a multitude of reasons.
The various rules and regulations around insider trading are notoriously complex and often rely on fuzzy concepts like “fiduciary duty” and discerning the exact source and materiality of information. This ambiguity creates room for corruption, can have a chilling effect on some forms of legal investment, pushes tax dollars into enforcement bureaucracies, and private dollars into legal teams. Societies where insider trading is legal are more able to operate on firm principles, such as judging people based on their actions, rather than their motivations.
These arguments should not be taken as a claim that legalizing insider trading isn’t without costs. The kinds of stock markets we have today are almost certainly dependent on such bans, and those stock markets have done a lot of good. But I think it’s also worth tracking the benefits that legalizing insider trading could bring, since there may be alternative avenues towards high levels of capital investment.
Revisiting the Problems
The three main issues with allowing insider trading are increased bid-ask spreads, fairness concerns, and risks of manipulation by executives. This last one can be handled by contract law, but what about the first two?
I claim that banning insider trading is a bizarre application of “fairness.” Imagine if “tall person basketball” was banned out of a sense that it’s unfair to short people that tall people have this natural advantage. I agree that in this world people below the height limit might sometimes have more fun playing basketball, but I wouldn’t describe that as any more “fair” than our world. Height would still (mostly) be an advantage, right up until it was disqualifying, and one could argue that it would be unfair to the people who would want to play the game but are too tall.
It seems reasonable for outsiders to demand prices that appear to favor them, when trading with insiders, and claim that otherwise it would be unfair, similar to how a short basketball player might demand a handicap. And indeed, this is exactly what it means for a market maker to widen the bid-ask spread when potentially dealing with an insider. Indeed, it even seems fine to ban insiders from trading on a particular market, akin to a particular basketball league that bans a class of people with an obvious (statistical) edge. But these are a far cry from a total ban.
So, if the fairness concern doesn’t hold up upon reflection, the only remaining problem with insider trading is that it pushes outsiders out of the market by widening bid-ask spreads. Worse prices for outsiders means fewer trades and less liquidity, which can lead to less overall investment in economic growth, damaging the greatest engine for making the world a better place.
This sounds pretty bad! But is it actually true that legalizing insider trading would result in less investment? Companies would still pay the same dividends, and be potentially juicy investments… If outsiders could somehow convince the market maker that they’re genuinely outsiders who don’t have privileged information, market makers could offer them discounted prices (i.e. narrowing the bid-ask spread), due to not having to guard against adverse selection.
And indeed, we see this all the time! Many market makers will offer price improvements to traders who they suspect are making uninformed, long-term investments in the market, such as individual retail investors saving for retirement. Since market makers are in competition with each other, there is a natural incentive to snatch up uninformed investors by offering them better prices.
Utopian Stock Markets
Investing in the future is how the world grows rich, and the most natural form of investment is in building companies.5 Utopia heavily prioritizes corporate investment, especially in contrast to consumption and speculation. Land value taxes make land speculation naturally unprofitable, and steeply progressive consumption taxes mean that very high earners are incentivized to invest almost all of their money, putting it towards productive uses, instead of buying luxury goods like boats. Even those on the poorer end of Utopia will often invest some money, as holding growing assets is widely understood to be a good way to save, rather than holding cash or physical goods.6
At the same time that Utopia encourages investment, it strongly discourages random people from deciding how to invest. In addition to the common wisdom that average people can’t beat the market,7 many local governments make it illegal for citizens to trade individual stocks without getting a license and proving basic financial literacy, partly because it is normal for insider trading to be totally legal in Utopia. Instead of picking stocks directly, almost all investors buy into funds.
An index fund automatically trades to balance a diversified portfolio based on straightforward metrics like market valuation, and such funds are the norm in Utopia. Because these funds are diverse, and execute trades according to a fixed, visible algorithm, market makers know they’re at low risk of being exploited when trading with those funds, and offer them prices that are comparable to our world.
But Utopia also has many funds that are managed by professionals who specialize in high-information trading within a specific sector of the economy. These managers work to cultivate relationships and insider status within companies, helping bring investment capital to bear in exchange for getting access to financial data, being able to sit in on important meeting, and other fundamentals. Most “insider trading” happens between these fund managers as they effectively make bets against each other based on their models of company trajectories and industry trends.
Executives and other decision makers inside Utopian companies are, as one might expect, bound by contract to not use their power to hurt the company for their own financial gain. This is typically accomplished by limiting when executives can sell company stock, and prohibiting them from short-selling (or otherwise betting against) the company until several months after they leave. While laws and other policies in Utopia are usually set by futarchy, and thus robust to similar manipulation, in the instances where a government selects a person to set policy or otherwise be in an executive role, they are similarly bound by contracts with the state.
Outside of the paternalism of licenses, Utopia puts up very few barriers to trading stocks (or bonds or certificates), and generally has far fewer market regulations. All stocks can be shorted, for instance. Company shares can be bought/sold on many different stock markets, including in countries other than where those companies are based. Markets tend to be open to everyone with a license, and operate 24 hours a day. This competition between markets means that very few have trading curbs (“circuit breakers”), and Utopians generally see market movement, including rapid decreases in price, as reflecting a realignment to the truth.8 Caveat emptor.
All companies in Utopia have the same quantity of shares: one. When someone buys or sells a share of a company, the amount is always expressed as a fraction of the company, rather than in arbitrary countable units. The primary way this is talked about uses order-of-magnitude modifiers for units — we can imagine someone wanting to buy “250 micro-shares,” for example. Many markets put a limit on the precision of how granularly stock can be split during a trade (just for accounting/computing purposes), but in theory, fractional shares can be traded at arbitrary precision.
Strong v. Repide, 213 U.S. 419 (1909). This Supreme Court case established that a director conducting stock negotiations had a duty to disclose facts unknown to the shareholder if special circumstances existed. It was an early step towards regulating insider actions but far from a general ban.
The SEC's adoption and interpretation of Rule 10b-5, derived from Section 10(b) of the 1934 Act, was crucial. Cases like SEC v. Texas Gulf Sulphur Co. (1968) significantly expanded the scope of who could be considered an “insider” and what constituted “material” information, moving towards the modern framework.
“The World Price of Insider Trading” by Utpal Bhattacharya and Hazem Daouk (Journal of Finance, 2002) finds that while insider trading laws existed in most countries with stock markets by the end of the 20th century, enforcement was often weak, suggesting the mere existence of the law isn't enough to impact markets significantly without credible prosecution. However, the trend globally has been towards stricter enforcement over time.
Larger bid-ask spreads reflect a decreased willingness to trade, but are not a cost, per se. While round-trip trades become more expensive, that money goes to market makers, rather than reflecting a destroyed resource. If trades are positive-sum, reduced trading makes people counterfactually poorer, and it’s worth being worried about that. But there’s good reason to think that most trades are close to zero-sum, in which case there’s no real loss of overall wealth associated with increasing the expenses on traders.
It’s tangential to the focus of this essay, but worth noting that Utopia has a class of productive asset that our world doesn’t: impact certificates, both for specific contributions to the public good (e.g. art and science) and for the overall impact of specific people. Utopians, to diversify, tend to buy a mixture of stocks, bonds, and certificates.
Utopians might look at “gold bugs” with a kind of horrified fascination. “Why is gold, a fairly useless metal, so prized in your world?” they might ask. “Yes, it’s fairly stable, heavy, and remarkably malleable. But it’s hardly as strong as iron, conductive as copper, or light as aluminum. Perhaps you expect the demand for corrosion-resistant electrical connectors to increase?” But of course, the real reason is even stupider: gold was semi-randomly selected to be civilization’s first currency, and people were too ignorant to understand where the value of money comes from. As a result, millions of people throughout history wasted their lives digging up gold, and markets repeatedly crashed due to being unable to control the supply of money, until people finally woke up and stopped tracking debt in units of metal. Even today, the price of gold is artificially high (e.g. Fort Knox) due to widespread confusion about money. The value of gold is much lower (and more stable) in Utopia, comparable in many ways to platinum.
Utopia does have some speculation on physical goods, such as commodities, but this is understood to be for savvy professionals, rather than a good store of value.
Despite the consumption taxes, many wealthy people in Utopia buy expensive jewelry, artwork, and other luxury goods. But these are understood to be signals of wealth, rather than efficient stores of value.
Utopia has an alternate (and more true) story to the efficient-market hypothesis: “Big markets attract geniuses who love to take money from suckers — those who, due to various biases, think they’re above (the money-weighted) average. If you don’t have strong evidence that you’re genuinely above average, you are probably the sucker, even when the price of an asset looks wrong.”
Stock market crashes have much less of a negative impact on Utopia due to better understanding of monetary policy. When the stock market contracts the money supply inflates to keep trade on “main street” normal. For more on this, see this essay.