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The Optimal Enforcement of Insider Trading Regulations

Peter M. DeMarzo, Michael J. Fishman and Kathleen M. Hagerty
Journal of Political Economy
Vol. 106, No. 3 (June 1998), pp. 602-632
DOI: 10.1086/250023
Stable URL: http://www.jstor.org/stable/10.1086/250023
Page Count: 31
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The Optimal Enforcement of Insider Trading Regulations
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Abstract

Regulating insider trading lessens the adverse selection problem facing market makers, enabling them to quote better prices. An Optimal enforcement policy must balance these benefits against the costs of enforcement. Such a policy must specify (i) the conditions under which the regulator conducts an investigation, (ii) the penalty schedule imposed if an insider is caught, and (iii) a transaction tax to fund enforcement. We derive the policy that maximizes investors welfare. This policy entails investigations following large trading volumes or large price movements or both. Insiders caught making large trades are assessed the maximum penalty, but small trades are not penalized. Given this policy, insiders trade most aggressively on news with an intermediate price impact but refrain from trading on moderate or extreme news.

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