The Optimal Regulation of Insider Trading

Abstract This paper models inside trading regulation with a well-defined objective and introduces an explicit measure of regulatory strictness. The regulator's objective is to minimize the trading loss of liquidity traders. With market professionals whose information-based trading is not regulated, the objective of regulation can be achieved by promoting competition between these market professionals and the insider. When stricter regulation induces improvement in the precision of the market professionals' information, tolerating some insider trading can be the optimal regulatory policy. It is also shown that allowing more market professionals to enter the market and disclosing information to them are as effective in achieving the regulatory objective as the direct restriction of insider trading. Journal of Economic Literature Classification Numbers: D82, G10, L13.