Should Insider Trading Be Legal?

Last week I read a pretty good synopsis on the insider trading trial of hedge fund manager, Raj Rajaratnam, a case I somewhat familiar with but haven’t followed very closely. For those of you who’ve been out of the loop, he is the Sri Lankan-born founder of New York hedge fund company, Galleon Group, a fund that was amongst the world’s largest at its peak with over $7.5 billion in assets under management. The hedge fund collapsed in October 2009 shortly after the arrest of Mr. Rajaratnam, who’s been charged with trading on non-public information for several companies, including Berkshire Hathaway’s $5 billion investment in Goldman Sachs. His alleged crimes netted him a total of $45 million.

The story itself is a pretty boring, plain vanilla tale of a hedge fund manager who probably ran out of ideas on how to legitimately beat the market, so he resorted to cheating. Nothing new... However, this story did get me thinking about whether insider trading itself should just be legalized. After all, what better way to even out the playing field between those in the ropes and those outside the building, than to allow the free movement of stocks in the marketplace based on all information. Based on my brief study, it seems that the benefits of legalized insider trading can be summed in these 3 points:

• The more information available, the more efficient prices become. The buying or selling of stocks by investors based on any kind of factual information would lead to more “correct” prices for those stocks.

• Fraud would get exposed earlier and in real time. The general argument here is that insiders who know of fraud, or as may commonly happen, are the perpetrators of fraud would sell their holdings of affected companies. Investors tracking the activities of insiders would not only know that something is amiss far quicker, but authorities could use this as a possible crime indicator.

• Insider trading happens in the market, its very difficult to prosecute, there are few deterrents against it, so why not just legalize it and thereby reduce the marginal advantages it brings insiders... Gotta admit this is a good point!

Although, I find these points to be pretty compelling, especially the last one, I have come to the conclusion that it would still be a wrong headed move. I think that a purposefully rigged market system, even if done under the strictest controls, would only work to undermine investor confidence over time. After all, if insiders were able to legally trade on information only they knew about, then might it not make sense that they would create information for which to trade on?