The following argument by John Allen Paulos1 sparked my interest in this question:
Consider “a pair of similar situations. In the first one you buy a stock ... and your earnings are $1,000 if it rises the next day and -$1,000 if it falls. (Assume that in the short run it moves up with probability 1/2 and down with the same probability.) In the second there is insider trading and manipulation and the stock is very likely to rise or fall the next day as a result of these illegal actions. You must decide whether to buy or sell the stock. If you guess correctly, your earnings are $1,000 and, if not, -$1,000. ... Your chances of winning are 1/2 in both situations. ... The unfairness of the second situation is only apparent.”Paulos isn’t defending insider trading, but just observing that the two situations are the same from your point of view even though the second one seems unfair. However, we can’t conclude that insider trading is harmless. These scenarios are idealized and there are other traders who may have been harmed.
If an insider trader makes, say, $1 million illegally on ABC stock, who has lost this $1 million? Let’s suppose that the insider trader buys 100,000 shares of ABC stock for $20 each on a Monday knowing that big positive news is coming, and he sells the shares for $30 each on Tuesday pocketing $1 million in profit. In very simple situations we can tell who has lost the million.
Suppose that the only trades in ABC stock on Monday and Tuesday are these two trades. Suppose further that the effect of the Monday trade on the market does not influence the actions of any other traders. Suppose even more improbably that the same party (let’s call him “chump”) takes the other side of both trades. In this simple and highly unrealistic scenario it’s obvious that the chump is the one who lost the $1 million made by the insider.
But what about a more realistic scenario where there is continuous trading in ABC stock, the market impact of the Monday insider trade influences other traders’ decisions (possibly even traders of other stocks), and more than one other trader is involved in the 100,000 shares traded by the insider on both Monday and Tuesday?
It’s quite likely that the $1 million loss is shared among many traders. Even people who made no trades may have lost money because the effect of the insider’s trades caused them to change their minds about making a trade. It’s even possible that some traders made money because of the way they were influenced by the insider’s trades.
The only way I can see of determining who loses and how much they lose is by running two world histories (inspired by the many-worlds theories in physics). In one history, the insider doesn’t make any trades and in the other one he does make his trades. We could then compare the outcomes for every market participant to see how much more or less money they have in the scenario where the insider makes the trades. Of course, this many-worlds experiment is impossible and we just can’t know for certain who shares the $1 million loss. It’s even possible that the total losses of all traders other than the insider won’t add up to exactly $1 million if the insider’s actions somehow affected wealth creation somewhere.
1 Quoted from the book A Mathematician Plays the Stock Market.