THE OPTIMAL REGULATION OF INSIDER TRADING

This paper models inside trading regulation with a well-defined object ive and introduces an explicit measure of regulatory strictness, The r egulator's objective is to minimize the trading loss of liquidity trad ers. With market professionals whose information-based trading is not regulated, the objective of regulation can be achieved by promoting co mpetition between these market professionals and the insider. When str icter regulation induces improvement in the precision of the market pr ofessionals' information, tolerating some insider trading can be the o ptimal regulatory policy. It is also shown that allowing more market p rofessionals to enter the market and disclosing information to them ar e as effective in achieving the regulatory objective as the direct res triction of insider trading. Journal of Economic Literature Classifica tion Numbers: D82, G10, L13. (C) 1996 Academic Press, Inc.