When it comes to the stock market, many people have likely heard that insider trading is bad and illegal. This crime actually comes with quite harsh penalties, too.
But why is this the case? Exactly what about insider trading makes it such a problem?
What is insider trading?
The U.S. Securities and Exchange Commission discusses the illegal trade of information also called insider trading. Understanding the purpose of insider trading and how it disrupts the stock market is key to understanding why it is illegal.
So first: insider trading happens when a person uses their inside information to get a leg up on competition in the stock market.
For example, if an employee hears their company will soon file for bankruptcy and then sells their stocks before it gets announced to the public, this is insider trading.
Why is it a problem?
The stock market stands on the trust of investors. The investors trust that people trading and selling and buying stocks do so honestly and without any unfair advantage over anyone else.
Insider trading makes things very unequal. It gives a smaller portion of people the ability to make decisions they would not have made without their information, which serves as an unfair advantage.
If the trust of the investors ends up shaken, then it could shake the foundation of the entire stock market. In essence, rampant insider trading can easily lead to the collapse of investor trust and thus the entire market.
This is why it faces such harsh punishments, with enormous fines of up to millions of dollars and jail sentences that can last multiple decades.