If you came here from outer space and tried to figure out what financial markets regulation is for, you might conclude that government interference in markets is designed mainly to prevent volatility. Think high frequency trading is to blame for recent volatility? Create a Tobin tax. Think that naked CDS trading or short selling enhances volatility? Ban them. Think speculators cause food price volatility? Impose position limits. Think stock or house prices have gone up too much? Tighten monetary policy. They've gone down too much? Loosen policy or allow a lot of below-market mortgage refinancing.
As a former toiler in the trenches of derivatives I have a residual fondness for volatility, though as an owner of a small and dwindling equity portfolio I am coming around to the view that small daily price increases are the best thing we can hope for in life.
Anyway. Roger Lowenstein has a long, well-reported, and to my taste depressing article in the Times Magazine this weekend about insider trading. It's already getting some attention in part because it includes the nugget that the director of SEC enforcement believes that "'anybody who is beating market indexes by 3 percent and doing it on a steady basis' could be a suspect," which seems like an unpleasant tax on good performance. (Good news John Paulson: if you insider trade, you're unlikely to get caught!)
Society has an interest in genuine — hopefully intelligent — research, the kind that asks whether Google or Apple will be the more dominant business down the road or whether oil reserves will run short. But the sort of desperate hypertrading that was Freeman’s specialty does not add to economic output or jobs or anything that matters. What it does do is ratchet up market volatility, contributing to the mind-numbing daily swings that send ordinary investors to the sidelines. Lately, thanks in part to that feverish trading, triple-digit market moves have become routine. The marked increase in volatility complicates the S.E.C.’s job considerably. When stocks jump or plummet in reaction to news, the payoff for those who trade on tips ahead of the news rises as well. Ferreting out who is prescient and who is crooked becomes more important than ever.
Lowenstein is not alone in thinking that high frequency - excuse me, "feverish" - trading does not help the world. What's new here is that he thinks - and presents the SEC as thinking - that a purpose of insider trading prosecutions is to dampen volatility and get "ordinary investors" off the sidelines. Or that it's to distinguish "genuine - hopefully intelligent - research" from trying to guess earnings numbers and trade on momentum.
Part of my objection is that high volatility tends to go with high correlation, making it harder, not easier, to make money on micro news - beating earnings may not help much in a generally down market. Which means that insider trading investigations go ever further afield from "corporate insider abused trust and sold his own shares on unpublished news."
But part of it is that imprisoning people to dampen volatility seems like an odd purpose to insider trading regulation. If you think that no one should benefit from inside information, then buy-and-hold investors who buy at the right time because of inside information are just as culpable as high-frequency traders who take their profits quickly. If you think that high frequency trading is bad, then do things directly designed to stop it - like a Tobin tax, or like looking directly at algorithms to see if they're destabilizing. With so many other tools to dampen volatility - and with the basis of the regulatory bias against volatility oddly unexamined - using increased insider trading prosecutions and prison sentences to crack down on "feverish" trading and not-socially-beneficial-in-your-view short-termism seems like overkill.