Main Street versus Wall Street: Efficiency and Wealth Redistribution Effects of Insider Trading

Abstract

By addressing the interaction between security market microstructure and the generalized agency conflict between managers and shareholders, we study the effects of informed insider trading on productive efficiency, price discovery, and wealth redistribution. Insider trading can lead simultaneously to production distortions and higher ex ante shareholder value because there is a redistribution of wealth from uninformed liquidity traders to uninformed outside shareholders through the optimal design of managerial compensation contracts; this is in contrast to the literature that considers insider trading to either unambiguously worsen the managerial agency problem or improve managerial incentives. Security market characteristics, such as the trading noise in the firm's stock, affect productive efficiency by influencing the manager's equity-based compensation and, in turn, equilibrium market liquidity is influenced by firm-specific characteristics. Insider trading can therefore have conflicting effects on productive efficiency and the informational efficiency of stock prices; it also generates wealth redistribution not only between uninformed and informed traders but between uninformed traders and uninformed shareholders as well. We identify the firm and market characteristics that determine the net welfare impact of insider trading.

Keywords: Insider trading, Generalized agency, Executive compensation, Market liquidity

JEL Classification: G12, G32, G34, J33, D82