Chicago Booth Review Podcast Is Insider Trading Always Bad?

John R. Birge: Since it can be manipulated, it is possible for people that have this very specific information that hasn't been released to the market yet, whether that drug gets approved or not, people that have that kind of information can have undue influence on the market.

Hal Weitzman: The UK's conservative party emerged a big loser from the elections of July 2024, earning the lowest share of the vote in its history, losing 251 seats in the House of Commons, and being kicked out of government. But dozens of officials personally made a profit on the election. In the UK, the ruling party chooses the date of the election, and the officials apparently used insider information to place hundreds of bets on what the date would be.

Welcome to the Chicago Booth Review Podcast, where we bring you ground-breaking academic research in a clear and straightforward way. I'm Hal Weitzman. Today, I'm talking with Chicago Booth's John Birge about how markets work and insider information. Such scandals have made regulators wary of allowing political betting to flourish in the US. But in September, Kalshi, a US financial exchange and prediction market, won a legal victory against the Commodity Futures Trading Commission, the industry regulator, enabling it to let people bet on outcomes such as which party will control Congress after the November elections. Is the return of political betting a good thing, or were regulators right to try to limit it, and is trading on insider information always negative?

John Birge, welcome to the Chicago Booth Review Podcast.

John R. Birge: Thank you, Hal.

Hal Weitzman: We're excited to have you because obviously we're in politics season, election season, and we want to talk to you about political prediction market and markets in general, betting in general, but we think of political prediction as very much betting. I'm going to bet that the Democrats are going to control the House, and the Republicans are going to control the Senate or whatever, and I can look online and find a market to bet on that, but there's a much more significant economic use of political prediction markets, isn't it? What is that?

John R. Birge: Well, businesses may be favored in some way by a political party and who's ever leading the government, and so businesses that might take advantage of that, maybe defense businesses might think that one party might favor them more than another, or maybe the AI industry thinks that one party might favor them over another. They may want to have some information about who's going to be the next government. And in that case, they may want to make investments, so it's more efficient if they are able to predict better what's going to happen in the future. They make more efficient investments. That's better for everyone if people are making investments that are more aligned with efficiency.

Hal Weitzman: So I guess there are two things that come out there. One is that the companies themselves might be doing something that is affected by one administration or another, right? If I'm going to import a lot of stuff from China, and I think that one the candidates wants to slap more tariffs on China, then I know that it would be bad for me if that candidate's elected, so I could bet on the other candidate, or I could hedge my bet in some other way. So that might be one thing. And then the other thing you're talking about is the information that companies derive from these political markets. So talk about those two things. One is, you addressed briefly, is this hedging my own investments, but the other one is learning information that might make my own decisions more efficient.

John R. Birge: Yeah. What we want from these prediction markets is that we acquire more information about how likely it is in this case that one candidate is going to win an election over another, or that they're going to control the government in some way rather than another, and that's information that can be of value to people. It can be of value to them because of their investments, because of what they might be able to receive on those investments. Then it can also affect the actions that they might take, like you're mentioning about hedging, that they may, if they do have an interest in a firm that's producing in China, oh, maybe they should think about producing in Southeast Asia, in Vietnam or Malaysia instead. So it informs them about the decisions that they'll make and try to be able to make better decisions on the basis of those predictions.

Hal Weitzman: Okay. What's wrong with polls? I mean, polls tell us a lot about what way people are going to vote. Why would markets be better than polls?

John R. Birge: Well, polls are often influenced by A, you want to be sure that you get a random selection, and they're often influenced by selection. People that don't want to tell pollsters what their actual opinions are, and there might be some evidence of that, Trump voters not wanting to say they're voting for Trump in 2016. We might've seen some evidence of that in terms of polls or the sort of classical example was an Alf Landon poll, and whenever Alf Landon ran for election, he only gathered eight electoral votes, but he had 320 in this poll because it was very biased, so we have to watch out for bias that can always arise in polls.

Hal Weitzman: But the sample size of people who bet on these political markets is very small, and I'm guessing also very skewed in some way, right?

John R. Birge: Well, the point of these markets is that people who do have information, information that's not already in the market, can enter them. If they're open for people to enter into them, and they have information, information that may have value, then they should be encouraged to enter. And that we should see that people who have that information come into these markets and therefore create more liquidity within.

Hal Weitzman: Right. I mean you'd expect, right, so you'd expect that if political markets grow, and United States is pretty far behind other countries in terms of political betting, but if political markets grow, the accuracy will improve.

John R. Birge: Yeah, I would think that that should happen. And as maybe you've mentioned about the court rulings allowing political markets, it may be that people were previously hesitant in the United States. The United States didn't have sports betting even when still not in many states, but sports betting wasn't legal in most of the United States and not legal federally, but now many of the states have made that legal, and the recent court ruling allowing the political betting as well to go on, that, I think, is encouraging more people to enter into the market, and you'll see these markets.

Hal Weitzman: Certainly, I grew up in the UK where-

John R. Birge: Where there's betting on everything.

Hal Weitzman: Yeah, and the odds on political outcomes are very often cited in news reports as much as polls perhaps are cited. But here it is different. And you talked about this case, which we mentioned in the introduction, but US regulators have typically taken a pretty dim view of political prediction market. So CFTC Chairman, Rostin Behnam, has said that these event contracts would effectively turn his agency into an election cop, so they'd be policing elections that these contracts are not in the public interest. Everything you've said so far has been very positive. Why do you think there's so much concern? What exactly is the concern?

John R. Birge: I think their concern is that they think that someone might be able to manipulate the market to influence how other people think, that people may, their thoughts about who should win the election may be based on looking at the results of the market, and if the market can't be manipulated, then that may have an undue influence on how people vote. It's less susceptible if more people are able to enter into the market.

Hal Weitzman: Okay. And I guess there's also a kind of moral thing, isn't there, that we just don't like? We don't think in America that gambling is good, and so gambling mix with politics seems bad.

John R. Birge: There is, I think, inherent in kind of American philosophy that gambling has some sort of immoral connotation associated with it so I think that that's also made America slower in adopting political betting in particular.

Hal Weitzman: Now, we've written up some of your research in Chicago Booth Review, which I'll talk about a little bit later, but I know you're working right now on papers about how manipulable these prediction markets are. So tell us about that, if you can give us some preliminary thoughts about that.

John R. Birge: Yes. Well, what happens in any of these prediction markets and can happen in these political markets, whatever occurs early in the, let's say, the opening of the market, that has greater influence on how the market actually reacts. So that means that bets that occur earlier in the market may have more influence than bets that occur when many people have already bet, and most of that information has been already absorbed by the market. It's possible that someone who has particular information, let's say information that is in excess of all the others in the market, that they're able to actually manipulate the market, push things in the wrong way. They may favor Trump, but then push towards Harris, but then at the very end, then they'll switch back to Trump and collect big rewards.

Hal Weitzman: Classic kind of corner.

John R. Birge: Classic kind of corner. And that can happen when they go very early into the market and when people don't have a particular opinion about what the outcome is going to be.

Hal Weitzman: So you talked about people who bet initially, so is that when the market is thinner, when there's less liquidity?

John R. Birge: Yeah, when there's less liquidity, the people-

Hal Weitzman: And then those bets are sticky?

John R. Birge: And those bets are sticky because people tend, the first thing you hear, you tend to, that sort of sets your belief. So that's to get people, it sets their belief, and then they sort anchor on-

Hal Weitzman: It's mental anchoring.

John R. Birge: It's a mental anchoring on what that initial belief was.

Hal Weitzman: Okay. And so your research suggests that the earlier the people who get in, the more they can kind of shape the way that prices play out.

John R. Birge: Essentially those early bets have more value than the later bets, and so they can spend a little bit at the very beginning to have a big influence over the entire process.

Hal Weitzman: So let me come back to the question about whether, does that mean that markets are manipulable at certain times?

John R. Birge: Particularly at these times when there's no information, and the market is just starting, and it's thinly traded because people don't have information. That's when those markets can be manipulated and when the information that those people do have is very concentrated. There's very few people, few people who know, for example, that a sports player is not going to play in a big game. If there are very few people who know that, they have a lot of power in the market. If they bet at the beginning, they have big influence on that.

Hal Weitzman: Okay. So it sounds like the regulators are concerned about manipulation, but by restricting activity-

John R. Birge: By restricting activity they're adding to manipulation. That's adding to manipulate. It's adding to it being manipulable, yes.

Hal Weitzman: Yeah. If you're enjoying this podcast, there's another University of Chicago podcast network show that you should check out. It's called Capitalisn't. Capitalisn't uses the latest economic thinking to zero in on the ways that capitalism is and more often isn't working today. From the morality of a wealth tax to how to reboot healthcare to who really benefits from ESG Capitalisn't clearly explains how capitalism can go wrong and what we can do about it. Listen to Capitalisn't, part of the University of Chicago podcast network.

John, let's move on from political prediction markets to talk about financial markets. It's different kind of thing because they're not event markets. It's not like we're waiting for a particular thing to happen. These are just general markets that are constantly traded, and there is deep liquidity, but there's still concerns about manipulation, right, in markets. So talk a little bit about that. What are the similarities between political prediction markets and financial markets?

John R. Birge: So political prediction markets, basically it's in a single event. We're looking to see who's going to win the election, so we have a single point in time at which we're going to determine what the payoffs are going to be. In a financial market, these payoffs are going on. As long as the firm is still operating, we're going to be able to trade in the stock of that firm for however long the firm is going to exist. So they have differences in terms of the timing.

However, the same kinds of conditions that can lead to manipulation in political markets can also lead to manipulation in financial markets. Knowing that a product, if you're pharmaceutical, knowing that a product is going to be approved for market, that can have a large influence on the value of a pharmaceutical firm. Those who have information about whether it's going to be approved or not, they have an advantage. Knowing whether a piece of legislation is going to be passed, that would be in favor of a particular company that can have an enormous influence on what the value of the firm is, and insiders can use that information to trade in the market and gain value from that.

Hal Weitzman: Rating information in the market. You talked in the first part of this podcast about how information coming out is good. It helps companies make better decisions, it helps us be better informed, but when I hear the terms insider and information, I think of insider trading, which is a criminal activity. So what is the distinction between the information that we want? Do we want all information coming out? Obviously we don't want people to engage in criminal activity, so how do you think about that?

John R. Birge: Well, yeah, we can ask the question about why it's a criminal activity. Why do people outlaw insider trading in securities markets? And we could think about that also from an efficiency perspective that can be manipulated. It is possible for people that have this very specific information that hasn't been released to the market yet, whether that drug gets approved or not, people that have that kind of information can have undue influence on the market, and they may be able to manipulate it. So in that case, it's a loss of efficiency, and then there's a good reason why there would be a law against that, that that's actually creating a hindrance to the market's operation. And that's actually been investigated empirically, that people have seen that when we have stricter enforcement of insider trading kinds of rules, we do see more activity in those markets. It's not a tremendous amount of data that supports that, but it does seem to be supported empirically.

Hal Weitzman: What exactly do we, just to clarify, what exactly do we mean by efficiency in this sense?

John R. Birge: We mean that we're getting more output for whatever input we have. For whatever input goes into creating goods and services, we're getting more of those goods and services, and that's what we would like from an economy. Whatever we put into the economy, we get more out of it.

Hal Weitzman: So when it's inefficient, we should outlaw it.

John R. Birge: If it's inefficient, then we should outlaw it. If it's something that can be manipulated or can be used to manipulate the market, then it shouldn't be.

Hal Weitzman: Okay. So what's the counter case? What's an example of insider information that is efficient?

John R. Birge: Well, let's say that actually my factories are really performing quite well right now, and they're producing products better than they ever have in the past. That's the kind of information that, well, actually, that's good for people to know, that people should know that these factories are really performing quite well and that maybe they're using a process that other firms should adopt. So other firms maybe should know that these factories are performing quite well, and that could be insider information that's beneficial to everyone.

Hal Weitzman: And I know that in your thinking on this, you're influenced by, as we all are, by Gary Becker, the famous U Chicago economist, Nobel Prize laureate, of course, and he had a view about insider trading. What was his view on insider trading?

John R. Birge: His view was that whatever is most efficient is what the pressure in any economy or in any political economy is going to bring out. So whatever is leading to the greater efficiency is what we should see actually hold in the end. So he would say if it's in favor of efficiency to limit insider trading, then there will be pressure to limit insider trading. However, if it was working in the opposite direction, we would see insider trading more loosely enforced.

Hal Weitzman: In the case, the example you gave, somebody knows that their factories are really producing really well, that's efficient because if that information comes out, other people might copy them, and the whole economy might grow, and everybody's better off, but I guess the concern is about trading on that. It's not the information part, it's the trading part. So why is it more optimal for that, just in theory. In theory, why is it better for that person to trade on that information rather than just release the information? After all, in America, we require a huge amount of information to be released publicly, and if people don't release that information, or if they trade ahead of time, that's considered to be illegal. So why, in theory, would it be better for the information to be traded on than just to be released?

John R. Birge: Well, releasing the information may lead to the same outcome in terms of efficiency, but if I just release the information, you may say, "Oh, well, that's just cheap talk. You might just be saying your factories."

Hal Weitzman: Even releasing the information could itself be a form of manipulation.

John R. Birge: It could be a form of manipulation, but by saying, "Oh, I have skin the game. I'm actually buying my own stock because I believe that my factories are very efficient," that gives more weight to the action of releasing the information.

Hal Weitzman: So is it possible we've gone too far with things like worrying about insider trading, that some of this activity at least, which is deemed criminal, might actually just be beneficial if it were allowed to play out?

John R. Birge: Yes. I think there's a fine line, and we should examine that, and I think examine it repeatedly to think about, are we enforcing insider trading rules in a proper way that's actually leading to a better economic outcome? It's something that we need to think about continuously. I think that's something that Gary Becker would've said as well, would've say, we always want to be pushing towards a better social outcome, and we should be looking at what's to lead to that better social outcome and continue to look at that.

Hal Weitzman: Okay. So what then is bad insider trading?

John R. Birge: When people act to manipulate on the information, so when it's very closely held, and people are able to act on it in a way that's actually contrary to the information that they hold, that's when there's the worst kind of manipulation.

Hal Weitzman: In other words, if they're taking the insider information they have and trying to manipulate the market.

John R. Birge: Trying to manipulate the market.

Hal Weitzman: To corner the market that we described.

John R. Birge: They know that it's a pharmaceutical firm, they know that their drug has just been approved, and they start short-selling the stock, knowing that there's an event coming up where it's going to be announced whether the drug is approved or not, and they start short-selling, that's the worst kind of manipulation.

Hal Weitzman: It seems like a lot of what you're describing is about the response to the information itself, not necessarily the information.

John R. Birge: Not the information, yeah. It's the response.

Hal Weitzman: How people use the information.

John R. Birge: How people use it.

Hal Weitzman: So maybe there's no such thing as insider information, there's only such a thing as insider trading,

John R. Birge: Right, right.

Hal Weitzman: Well, we all have insider information in some sense. We all have our own data points.

I know you've done some research that we've written up about market manipulation and how the role of middlemen, I guess market managers can control that manipulation in some sense through charging commissions. Just explain.

John R. Birge: Yeah, so the way that these markets can be manipulated is that people are able to trade on one side and then trade on the other side. So trade against the information they have then trade for the information, and each time they do that to collect a return on that, and they can do that many times over, if there is no commission, they can keep on doing that many times over and always collecting pennies each time they do it, but they can earn lots over the long term by doing that. When there's a commission, because every time they do a trade, they're losing a little bit in that commission, they're not able to continue to do that, so they can only trade effectively once or maybe a few times, and that limits the ability of manipulators or people with insider information to go out and try to manipulate the market.

Hal Weitzman: Okay. This is in your model.

John R. Birge: That's in the model.

Hal Weitzman: I'm thinking how does that translate to, I'm sure that Charles Schwab would love hearing what you've just said, but how does that translate to a world where it's become free to trade in the market, and you can trade fractionally in the market, so you can trade pennies, really? And there's the whole market itself is controlled by algorithms that trade at the speed of light.

John R. Birge: Yes. Well, that's one of the downsides of markets in which we have very low commissions, even though it means it has an upside in that more people are able to enter into the market because there's lower transaction costs, so they're able to enter into the market, and that brings a lot of liquidity. So there's a balance there. There's more liquidity in the market because of that, but there's also the possibility of manipulation, which leads back to why we might want to enforce insider trading rules even more now that we have very low commissions. Now the commissions are very low, we want to make sure that we don't have the bad kind of insider trading that actually leads to manipulation and leads to something that's not good for the entire economy.

Hal Weitzman: Oh, I'm guessing the other responses we bring back, the $7 a trade.

John R. Birge: Yeah, I'm sure Charles Schwab wouldn't mind having $7 a trade.

Hal Weitzman: John Birge, thank you so much for coming on the Chicago Booth Review Podcast.

John R. Birge: Thank you, Hal.

Hal Weitzman: It's been great fun.

That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis, and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research. This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe, and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.