Insiders should not only be permitted to trade, they should be encouraged

Prediction Markets and Insider Trading from Bainbridge, my take below:

Banning traders with the best information does not benefit any of the market participants or the market itself. Most people would agree that insider participation ensures market pricing is accurate. Excluding their knowledge will cause the market to decrease in relevance since it couldn’t be relied on to aggregate all available information about an event. Even defining what constitutes an “insider” for news/event related contracts would be a bigger rules debacle than the NKM contract.

Traders don’t benefit from mispricings; a winning trade due to banning of knowledgeable participants sounds like luck or some kind of subsidy rather than skill. Decision markers will also suffer if the markets do not accurately reflect the odds of an event occurring. An academic might make the argument that liquidity would suffer if it was known that insiders were able to trade. However isn’t that already implicitly the case with every prediction market contract currently? Traders, so far, don’t care if there are insiders trading.

Defining an insider would be an impossible and silly task. Would a meteorologist be banned from trading weather contracts? After all they can use fancy modeling equipment and satellite data that most people wouldn’t be able to access. Being an insider is still no guarantee of a win. Even the ultimate insider on the NK missile contract, Kim Jong-il himself, would have lost if he longed the contract on TS. The exercise of defining an insider for most of the news contracts quickly turns absurd. Of course they shouldn’t be banned, they can’t even be defined! Does any knowledgeable market participant have an obligation to withhold information? Since it would be to their detriment to do so, who would benefit? It’s not the traders who are trading on off-prices. And it can’t be decision makers who are making decisions without using all the information that could be available.

The very idea that there is some special type of “insider knowledge” that shouldn’t be used for trading is an advancement of the idea of information socialism. There will always be parties with more information than the general public and those knowledgeable participants should be able to profit from their superior knowledge. What would be the point of acquiring it otherwise?

Free markets work. If demand exists for a market free of insiders than existing firms will profit from moving into that space. Any exchanges banning insiders would be a big step in the wrong direction.