The Optimal Enforcement of Insider Trading Regulations

Posted: 25 Jun 1996

Date Written: May 1996

Abstract

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

DeMarzo, Peter M. and Fishman, Michael Jay and Hagerty, Kathleen M., The Optimal Enforcement of Insider Trading Regulations (May 1996). Available at SSRN: https://ssrn.com/abstract=10084

Peter M. DeMarzo

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-1082 (Phone)
650-725-7979 (Fax)

HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Michael Jay Fishman

Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States
847-491-8332 (Phone)
847-491-5719 (Fax)

Kathleen M. Hagerty (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8345 (Phone)
847-491-5719 (Fax)

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