Insider Trading at Administrative Agencies

Stock trades that publicize nonpublic information benefit the economy, but when government agencies get involved, additional ethical issues arise

By Giorgio Castiglia

A recent Wall Street Journal investigation shows that many federal agency officials enjoy trading stocks, and some of them may have traded on information not available to the public. The investigation led to the following major findings:

• Across 50 federal agencies, more than 2,600 employees reported owning stocks of companies while those companies were lobbying their agency.

• Officials at the Federal Trade Commission are particularly given to trading stocks of companies that are targets of the commission’s enforcement actions.

• Some five dozen individuals across five agencies reported trading stocks of a company shortly before their agency brought an enforcement action against it.

Should government officials be banned from engaging in such trades? Given the difficulties that could arise from monitoring and policing this kind of trading, the costs of banning it outright may outweigh the benefits. But insider trading by government officials can have uniquely negative consequences, so some additional limits on this trading are probably warranted.

Insider Trading by Business Insiders

In the business world, insider trading refers to any situation where certain individuals—usually top executives, board members and others with access to privileged information based on their position in a company—profit from the sale of stock based on “material, nonpublic” information. The practice is often maligned as unfair and unethical, and the Securities and Exchange Commission is tasked with enforcement under section 10(b) of the Securities Exchange Act, which prohibits fraud in the sale of securities, and section 16(b), which prohibits short-term windfall profits from access to privileged, inside information.

Little thought is given to the possible benefits of insider trading, however. In 2009, George Mason University economist Don Boudreaux penned an op-ed in the Wall Street Journal arguing that insider trading is not the boogeyman it is often made out to be. Rather, such trades help prices adjust to where they should be based on all the relevant information, not just that which is publicly available. This price adjustment actually has benefits for outsiders, such as long-term investors, both individuals and institutions. As Boudreaux writes: “Prohibitions on insider trading prevent the market from adjusting as quickly as possible to changes in the demand for, and supply of, corporate assets. The result is prices that lie.” Prohibiting insider trading prevents the price of a stock from revealing the true underlying economic fundamentals of the company in question.

In other words, prices that are artificially bolstered by insider trading prohibitions actually mislead and harm outside investors, who continue to make trades on incomplete information until the market corrects. Of course, even without such prohibitions, outside investors may lose money in the short term while insiders profit, since the latter have the advantage of knowing the relevant information before everyone else does. But leaving questions of fairness aside, the possibility of receiving huge payouts from trading on inside information raises the cost to knowledgeable insiders of being dishonest about the fundamentals of the company and the quality of its management. This will save outsiders time and money in the long run.

The Importance of Price

The key to this argument is taking seriously the communicative and coordinative role that honest prices play in a market economy. Prices aren’t just randomly selected numbers and dollar signs; they are pieces of information that reflect the real underlying relative scarcities of resources prevailing in the economy. When large trades are made on the basis of “insider” information, the stock price moves to reflect what the insiders know, allowing others to make better decisions with respect to ownership of that stock, given that this knowledge is now available to them as well. Insider trading can solve a crucial incentive problem, that is, getting insiders to signal serious flaws in company management.

Models in economics textbooks often display prices that move instantaneously when the underlying economic circumstances change. In the real world, however, information needs to be communicated in order for prices to move, and this can take time. It can even be an ugly process at times.

Take the recent FTX debacle. This is an imperfect example because FTX is privately rather than publicly owned, and so it has no stocks that can be shorted or held on the basis of inside information. In the case of FTX, it looks like questionable management practices persisted for some time, but the release of information in a November 2 report from CoinDesk signaled to many that it was time to remove their investment in the crypto exchange. Binance, a rival exchange, announced that it would liquidate a large portion of its holdings of FTT, the cryptocurrency issued by FTX. This action served as a signal for others to offload their FTT holdings as well.

Ideally, company management would always be responsible. However, assuming there is a risk that some bad practices will eventually arise, management problems can best be solved by giving insiders an incentive to tell or signal to the broader public what is going on. Users of FTX’s crypto trading platform were put on alert by the CoinDesk report and Binance’s subsequent sale of FTT. Perhaps information on Sam Bankman-Fried’s management practices would have come to light sooner if FTX insiders had had an incentive to legally profit by selling their own FTT holdings on the basis of inside information about those practices.

For publicly owned companies, by contrast, when insiders share information by selling or shorting stocks, their actions show that the current evaluations of a company are flawed, which gives outside investors more information to make better decisions. A comprehensive solution to unscrupulous management should ensure that insiders have every incentive to share information about fraud with outsiders. Permitting insider trading would not be a panacea for this incentive issue, but it could go a long way toward addressing it.

Not all insider trades are equal, however. Whether to permit insider trading may depend on the specific issues at play. Consider the recent case of employees at Coinbase, another crypto exchange, who successfully made windfalls by trading on inside information about upcoming announcements of new cryptocurrencies to be added to the Coinbase platform. Shortly before such an announcement, the individuals secretly bought up large quantities of the digital currency in question and sold them post-announcement when the prices shot up.

The key difference between this case and the FTX example is that in the former, Coinbase’s incentives to restrict insider trading align with their customers’ interests. Coinbase wants to deter inside trades not because it is afraid that fraudulent practices will be revealed to the public, but because that activity will undermine customers’ confidence in its platform. Coinbase worked extensively with the Justice Department to weed out the culprits and did so successfully.

Insider Trading by Government Officials

Even if insider trading can be beneficial as a mechanism to keep companies honest, what about government officials who use inside information to buy and sell stocks of companies they investigate? Is “insider trading” within federal agencies ethically worse than such trading in the private sector?

In a strict sense, insider trading will have a similar effect on the market whether it’s done by business insiders or government officials. These trades will incorporate pertinent information into stock prices more quickly than if such trades are prohibited. The key difference between insider trading by business insiders and by government officials comes from the government’s power to coerce. If key decision-makers within administrative agencies decide to promulgate rules or bring enforcement actions based on the benefits they believe these actions will have on their own financial holdings, their actions would indeed be fundamentally corrupt.

One can see the ethical issues that would arise from permitting such trades without any type of scrutiny. Government officials could engage in enforcement actions, or conduct themselves within enforcement actions, in such a way as to serve their own interests at the expense of the public’s. This problem could be somewhat mitigated, however, if information on government officials’ trades were made easily available to the public. Then it would be easy to identify any enforcers who are using inside information and choosing to enforce and regulate based on how it will benefit them financially. Those corrupt officials could then be removed from their posts for dereliction of duty.

However, this information about government officials’ stock trading is not readily available. The Wall Street Journal investigators had to build their own database of these trades. Evidence shows that agencies often don’t enforce their ethics rules against stock trading. When the Office of Government Ethics uncovers a financial holding situation it deems ethically dubious, agencies waive the rules in many instances, even though there is a criminal conflict-of-interest law on the books that is supposed to prohibit government employees from presiding over matters in which they have a financial interest. Nonenforcement is simply the status quo. We don’t want to disincentivize bright minds from working in government agencies by not allowing them to have a financial stake in the growth of American companies, but clearer rules of disclosure and transparency around public officials’ stock ownership may help agency employees both maintain good portfolios and increase public confidence.

Contrary to popular belief, giving insiders incentives to reveal when things have gone awry—by trading on inside information—can help protect against insidious, systemic malinvestment. Even insider trades by government officials can help move prices to reflect underlying realities, just as private insider trading does. The danger is that officials could choose to bring enforcement actions or push for policy changes—using the coercive power of the state, which private actors alone cannot do—with the purpose of affecting stock prices for personal financial gain. For this reason, even if insider trading were to be permitted for business insiders, government officials who engage in such trading should be subject to additional oversight.