The Optimal Enforcement of Insider Trading Regulations
Posted: 25 Jun 1996
Date Written: May 1996
We consider the problem of enforcing insider trading regulations. Regulating insider trading lessens the adverse selection problem faced by market makers, enabling them to quote more favorable prices for traders. These benefits of regulation, however, must be balanced against the costs of enforcement. In designing the optimal enforcement policy the objective is to maximize the expected utility of the traders who are not insiders. Specifically, the problem is to design an enforcement policy consisting of (i) the circumstances under which the regulator undertakes a costly investigation to detect the presence of insider trading; (ii) the penalty schedule for insider trading; and (iii) a transaction tax to be levied and used for the regulator's budget. Among the results, we show that the optimal policy has the following features. Investigations are triggered by large trading volume and/or large price movements. Insiders caught making large trades are assessed the maximum legal penalty, while small trades are not penalized. Given this optimal enforcement policy, we find that an insider would not trade aggressively on very modest or very extreme news, but would trade most aggressively on news leading to an "intermediate" price change.
JEL Classification: G12, G14, G18, K22
Suggested Citation: Suggested Citation