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The Value of Insider Trading

This illegal activity goes a long way in adding to the sum of knowledge in the market

The recent case in the US of prominent hedge fund manager R. Rajaratnam has put the spotlight on insider trading. Rajaratnam, who apparently, knows the who’s who of the tech industry in the US, was in contact with a group of people well-placed to feed him information that enabled him to trade profitably. This appears to be a long-running and well-organised operation. News reports said that this was the biggest case of a hedge fund manager systematically creating a network of insiders to enable him to invest better.

Those who claim to know how Indian markets really function would probably find it natural that this network’s most prominent members were of South Asian origin. ‘Everyone knows’ that insider trading is rampant on the Indian markets and that promoters riding their own stock up and down is not just a routine, but an almost mandatory activity. Not just that, many small investors (especially those who have recently lost money) have a conspiracy theory regarding stock markets in which money is always made by those who have inside information at the expense of those who don’t.

All this is likely to be true, but it actually doesn’t matter. Or rather, insider trading matters, but its impact may actually be neutral to positive. To understand this, one must distinguish between official insider trading (as in stock owned by management whose trading is declared to the exchanges regularly) and what Rajaratnam and others do. This type of insider trading is based on information sold by insiders to brokers and investors. In the Rajaratnam case, some of these insiders aren’t even senior management—they’re just employees or even outsiders like vendors and consultants who happen to have non-public information that could move a stock.

I think that this kind of insider trading is not only unstoppable, but it’s actually useful. The interest of the investing public is best served by having more and more high-quality information getting factored into a stock price. There’s no one in the media or the investor community who doesn’t know that the official information feed from corporates is a highly sanitised version of reality. It’s mostly just a PR spin that is designed to make investors bullish and is actually another substance that is spelt with almost the same alphabets as bullish.

If there’s anyone out there, insider or outsider, who is leaking information that is injecting a dose of reality into a stock’s price, then that’s good for investors, no matter what the original motive of the leak.