Insider Trading: Supermarket Lines, the Stock Market and Chance

Dec. 6, 2009 — -- Before getting to the topical issue, let me start with a simple puzzle.

Which of the following two situations would you prefer to be in?

In the first one, you're given a fair coin to flip and are told that you will receive $1,000 if it lands heads and lose $1,000 if it lands tails.

In the second, you're given a very biased coin to flip and must decide whether to bet on heads or tails. If it lands the way you predict, you win $1,000 and, if not, you lose $1,000.

Although most people prefer to flip the fair coin, your chances of winning are 1/2 in both situations, since you're as likely to pick the biased coin's good side as its bad side.

Bias Doesn't Change Chance of Winning

Consider now a similar pair of situations.

In the first one you are told you must pick a ball at random from an urn containing 10 green balls and 10 red balls. If you pick a green one, you win $1,000, whereas if you pick a red one, you lose $1,000.

In the second, someone you thoroughly distrust places an indeterminate number of green and red balls in the urn.

You must decide whether to bet on green or red and then choose a ball at random. If you choose the color you bet on, you win $1,000 and, if not, you lose $1,000. Again, your chances of winning are 1/2 in both situations.

Finally, consider a third pair of similar situations.

In the first one, you buy a stock that is being sold in a perfectly efficient market and your earnings are $1,000 if it rises the next day and negative $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 situation, there is insider trading and stock manipulation -- a company official confidentially tells his niece who tells her botox doctor who tells all his patients -- and the stock very likely rises or falls the next day as a result.

You must decide whether to buy or sell the stock. If you guess correctly, your earnings are $1,000, but, if not, you lose $1,000. Once again your chances of winning are 1/2 in both situations. (They may even be slightly higher in the second situation since you might be one of the doctor's patients.)

Insitutionalized Insider Trading Could Cause Greater Harm

In each of these pairs, you have the same chance of winning in the second situation that you do in the first. This is garden-variety insider trading and, though I don't defend it, I do suggest that, although resentment-inducing, it simply introduces another unpredictable factor affecting the price of a stock.

If, however, insider trading is pervasive and institutionalized, the harm it causes is vastly greater, yet scarcely visible. It can destroy the financial system.

Before getting to this, what about supermarket lines and insider trading?

Who Wants to Be Stuck in the Slow Lane?

Consider the annoyance you feel when you're stuck in a supermarket line that doesn't seem to be moving. Other lines seem to be proceeding nicely past the cashiers, but not yours. You might even switch lines only to discover that your new line suddenly becomes as pokey as the one you left.

Unless you possess an unusually equable Buddhist temperament, this trivial delay can be really irritating and is one reason some stores have instituted single lines with the first in line going to the next free cashier.

The model of insider trading with coins and balls is simplistic and theoretical, but at least has the virtue of being clearly wrong and quite limited. This can't necessarily be said about the proprietary computer code that companies like Goldman Sachs employ to make high-volume trades almost instantaneously. (Goldman is not alone. Renaissance and other high-tech investment groups have their own very fast proprietary code.)

Proprietary Codes and Almost Instantaneous Transactions

If, as the writer Matt Taibbi, the blog Zero Hedge, economics Nobel Prize winner Joseph Stiglitz and others have suggested is a possibility, Goldman were to use its lightning fast programs to carry out its own trades before those of its clients, then it could, in effect, move to the front of any supermarket (or, in their case, super market) line.

By being privy to others' intended trades, and immediately and preemptively acting, it could reap profits that would make inside traders of the past look like underlings stealing pens and staplers from the company storeroom.

However accomplished, Goldman has enjoyed more than $100 million in trading revenue on more days than it hasn't this year.

'Supermarket Cop' Could Prevent People From Skipping the Line

Responding to Zero Hedge, Goldman spokesman Ed Canaday has stated, "Your suggestion that we monitor our Web site to facilitate front-running is untrue and offensive," but even if these unproved suspicions of "front-running" are false and Goldman is only using its extremely expensive, sophisticated programs to swiftly carry out others' trades, these other clients will still move ahead of ordinary investors, who will inevitably find themselves in the slow-moving line.

It's not surprising that Goldman's code (and that of others) is very valuable and jealously guarded, as evidenced by a recent story about the FBI's arrest of an Russian emigrant programmer alleged to have stolen parts of it.

One partial solution may be to randomly impose a one- or two-minute delay on some trades, a sort of supermarket cop who occasionally and briefly prevents people from skipping ahead in line. A reform of this general sort is something that Congress or the SEC should at least consider.

The prospect of thousands of people making billions of dollars not because they produce anything of value or because they efficiently allocate resources to worthy companies, but simply because they have better, faster software is not a pleasant one to contemplate. And it's also a waste of the talents of the very intelligent people who write and implement the software.

John Allen Paulos, a professor of mathematics at Temple University in Philadelphia, is the author of the best-sellers, "Innumeracy" and "A Mathematician Reads the Newspaper," as well as (just out in paperback) "Irreligion: A Mathematician Explains Why the Arguments for God Just Don't Add Up." His "Who's Counting?" column on ABCNews.com appears the first weekend of every month.