DP3292 | Regulating Insider Trading when Investment Matters

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We analyse the effects of insider trading on real investment and welfare, and the consequences of different regulatory policies: a disclose-or-abstain rule, ?fair? disclosure, laissez-faire and forbidding insider trades based on ?precise? information. We perform the analysis in a model in which all traders are rational expected-utility maximizers and aware of their position in the market. We compare the equilibrium with insider trading with the equilibrium in the same market without insider trading in two scenarios: costly and costless information acquisition. We find that with costly information acquisition an abstain-or-disclose rule tends to be optimal while with free information acquisition laissez-faire is better. This suggests enforcing an abstain-or-disclose rule with a high standard of proof for inside information. This rule of thumb advocates a laissez policy both for selective disclosure and in high-tech industries. Our approach uncovers the pitfalls of welfare analysis in the noise trader model.