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Insiders raise the cost of capital
The case for insiders
Economist Robin Hanson of George Mason University has made the case for decades that prediction markets should allow insider trading. Stock markets prohibit it, but a prediction market built to allow and even exploit it becomes more efficient. An insider at Apple or Google gets the information out fast because they profit from it, and everybody gets better information.
The cost is trust
The cost is trust. Trust in a market is a public good: the belief that taking part means a somewhat level playing field. Everyone knows some people spend more on their research, and a media company owner may know more than a typical investor, but nobody has an inside look at the companies themselves.
Cost of capital and law
Financialize information with no prohibition on insider trading and that trust erodes. Everyone trying to raise money in those markets ends up with a slightly lower price earnings ratio, so the cost of capital goes up. Trading on material nonpublic information is already against the law for members of Congress and their staffs, and the line blurs when they meet with company executives or work on legislation that moves a sector. Goldman Sachs has told its staff not to trade in prediction markets except on sports.
How would insider trading speed up prices?
A market price is a summary of what traders collectively believe. When someone who knows something trades on it, the price moves before the news is public. Everyone else can then read that move as a signal. Robin Hanson's proposed designs for prediction markets rely on this effect, in which the people with the best information are paid for revealing it through their trades.
Why does trust lower a market's cost of capital?
Traders who fear that others know more demand protection against losing to them. In market makers, that protection shows up as wider gaps between buying and selling prices, a result formalized in the 1985 Glosten and Milgrom model. Investors who expect to be trading against insiders also pay less for shares, which raises the return companies must offer. A 2002 study in the Journal of Finance by Bhattacharya and Daouk found that countries' cost of equity fell after their first prosecution under an insider trading law.
Why is trading by Congress already illegal?
Members of Congress are not exempt from insider trading law. The STOCK Act of 2012 spelled this out, stating that members and their staff owe a duty not to trade on confidential information they get through their work. It also requires them to report most trades within 45 days. The law was passed after a 2011 television report on lawmakers' trading drew wide attention.
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