Informed Trading and Its Regulation

Informed trading--trading on information not yet reflected in a stock\u27s price-- drives the stock market. Such informational advantages can arise from astute analysis of varied pieces of public news, from just released public information, or from confidential information from inside a firm. We argue that these disparate types of trading are all better regulated as part of the broader phenomenon of informed trading. Informed trading makes share prices more accurate, enhancing the allocation of capital, but also makes markets less liquid, which is costly to the efficiency of trade. Informed trading thus poses a fundamental trade-off in how it affects the two principal functions served by the stock market--information and liquidity. This Article takes this basic tradeoff and develops an analytic framework, drawing on microstructure economics, modern finance theory, and the theory of the firm, to identify which types of informed trade are socially desirable, which are undesirable, and how best to regulate the market as a result. A key observation is that the time horizon of the information on which an informed trade is based--the latency before it would otherwise be reflected in price-- crucially determines both the strategies of those trading on it and the social value of such trading. Disaggregating traders and trading strategies in this way provides powerful new insights into how we can use regulation to deter socially undesirable forms of informed trading and promote socially desirable ones. The central contribution of this Article is the systematic application of the insights of our framework to illuminate a vast array of legal rules and doctrines--typically considered in isolation--in light of their effects on different kinds of informed trade. These include Rule 10b-5 as applied to insider trading, Exchange Act Section 16(b), Reg. NMS, mandatory disclosure rules, Reg. FD, New York\u27s so-called “Insider Trading 2.0” policy, and various stock exchange regulations. The Article thus lays the foundation for evaluating this array of rules, and on this basis suggests a series of reforms to the current framework of securities law