Submitted by Martin Sibileau of A View From The Trenches [15],
Public securities, ceteris paribus, should trade at a discount to private securities, to compensate for the risk of lack of control and transparency.
In the past weeks, there has been a “revival” of news related to high-profile inside trading cases. And in an informal conversation at the Ludwig v. Mises Institute of Canada, one of our readers, coincidentally asked our view on insider trading. This left us feeling that it would perhaps be a good time to offer an “Austrian” (Hayekian) perspective on the subject in today’s letter. The topic, no doubt, could be included in the next edition of Walter Block’s must-read book “Defending the undefendable [16]” (In this spirit, Mr. Block, please, accept our contribution to your list of undefendables!).
Insider trading is accurately pictured in that great movie called “Wall Street”, by a famous line of Gordon Gekko to Bud Fox. Gordon said: “If you’re not inside, you are outside”. Gordon was right. If only people understood that this is just a natural thing… It has nothing to do with ethics. It is neither good nor bad. It is only natural that those who are involved in the daily operations of a company will necessarily count with more information than those who are not. The reverse would be the odd thing. On the same basis, we must acknowledge that ambition is also a natural characteristic of human beings. It is only natural to expect that those with more information than the rest will use it to their own benefit.
Yes, we know that there is something in our argument that may not make sense to you…and we dare to guess that it is because you expect fairness when you invest your savings in a public security (i.e. a stock or a bond). But in all honesty…have you ever asked yourself why you expect fairness? You give your capital to a firm whose management you don’t know, where you don’t have voting rights unless your participation is significant, with the hope that someone else may later buy it from you at a higher price and that in the meantime, you cash a nice dividend… and you expect fairness? Really? Why would you do that to yourself?
We are not implying people should not trust those who issue or market these securities. But if they do, they should recognize that there is the risk that they may suffer a loss due to insider trading. It is a risk like any other one. How do you value it? The price of this risk would be measured in relative terms and, in this case, it would be measured versus private securities.
Public securities, ceteris paribus, should trade at a discount to private securities, to compensate for the risk of lack of control and transparency. Yet, today, the opposite applies: Private trades at a discount to public. And this, we think, is the crux of the matter, because it is certainly not fair to risk one’s capital to insiders, when one doesn’t receive a discount.
But…how did this distortion in the relative price of public vs. private debt or equity come about?
First, investors have a false sense of confidence and believe that insider trading is a “tail risk”, because governments make it illegal. Rather than allowing the price differential between public and private securities to signal investors the risk at stake, governments simply establish a cost to breaking the law. Of course, every time that the benefits of breaking the law surpass the associated costs (adjusted for the probability of getting caught), an insider will take a chance. Clearly, the likelihood of this happening increases considerably when the value of the capital of a company is subject to high volatility, because the benefits of inside trading increase while the associated costs (fines, penalties) remain unchanged.
It is this analysis of the suppression of an important signal, that led us to suggest at the start of the article, that this perspective is “Hayekian”. In Von Hayek’s view, Economics is the study of social cooperation, where prices signal important information. When governments ban insider trading, an important risk signal for the market is suppressed. If the spread (reflecting this risk) between public and private securities was not suppressed those issuing securities publicly would have a self interest in narrowing such spread. And we are sure they would act to reduce reputational risk to reasonable levels.
Having said this, we have to next ask ourselves why that spread between public and private securities is not allowed to exist. Why is insider trading suppressed? And its answer brings us to the second point…
Private securities today trade at a discount to public securities, ceteris paribus, mainly because public securities are more “liquid”. But as we wrote before in an unrelated letter [17], liquidity is not a characteristic intrinsic to a particular asset. Therefore, what makes these public securities more liquid than the private ones? It would seem that by definition, the fact that they are public should be enough to prove that they are more liquid. But we all count with an asset called “money” to have liquidity (i.e. a medium of indirect exchange) and nobody in his/her right mind would consider holding a public stock or a bond for liquidity purposes. What is meant by liquidity in public securities is the relative ease with which one can sell them either because an investment target has been met or because one wants to get out of them sooner rather than later. Volatility therefore plays a role in the appraisal of that liquidity, which also comes at a cost, in terms of a bid/ask spread.
Under these terms, that relative ease to get in or out of a public security is clearly facilitated by the fact that we have two additional government-induced distortions.
One distortion, present in most developed nations, is the existence of coerced collective savings, also known as pension plans. These are managed by people who naturally seek to gain economies of scale and demand large pools of assets to dump what they have forcefully taken from the contributors. To make their lives easier and under the flawed belief that in fiat currency systems sovereign debt is risk-free and one can effectively diversify across levered asset classes, they simply allocate funds based on defined mandates and portfolio allocation “theorems”. Public securities, packed with obsequent ratings, come in handy.
Another distortion is the existence of banking institutions that benefit from the leverage provided by reserve requirements below 100% and the backstop of lenders of last resorts (i.e. central banks), to make markets for the public securities. They do this in exchange of ancillary businesses: M&A, advisory, underwriting mandates, etc. These institutions, most often, first provide the future issuers of public securities with liquidity lines to gain their business and later to take them public. But think about this for a moment…have you ever seen a carpenter tell you that if you hire him to do your new kitchen cabinets, he will give you, as a perk, a $10,000 line of credit at Libor+100 bps? What would you think if he did? Then, why is nobody surprised when, on a daily basis, we see bankers approach a company to tell them that if their banks are hired to provide cash management or underwriting services, they will receive a 5-yr revolving line at L+100 bps. Evidently, liquidity is simply treated as a perk and this only happens because someone is supplying it at the expense of others (i.e. those holding the fiat currency as a store of value).
If insider trading was allowed and public securities traded at a premium vs. private ones, no company would see the benefit of paying underwriting or advisory fees to these banks, to access a more expensive market. Instead, banks would have to compete with private equity/debt funds to win the business of the issuers.
If coerced savings were forbidden and each one of us had to manage his/her own savings, we would demand more rigorous conditions and would do a better job diversifying them (caveat: at a macro level).
If banks did not count with leverage on a lender of last resort, they would not be out in the market giving away cheap revolving lines to private companies, with the intention of taking them public later.
And finally, we must never forget that even if insider trading was not illegal, we would still not be forced to buy public securities, while instead, we must always remember that we are indeed forced to use fiat currency and that its price is completely determined by insiders who meet every two months to decide its value. Yet only a few seem to note this.