The prohibition against insider trading is becoming increasingly anachronistic
in markets where derivatives like credit default swaps (CDSs) operate.
Lenders use these instruments to trade the credit risk of the loans they extend.
By design, CDSs appear to subvert insider trading laws, insofar as lenders rely
on what looks like insider information to transfer or externalize the risk of a
loan to another institution. At the same time, the harm caused by using insider
information in CDS markets can depart radically from the harms envisioned
under existing case law. In the traditional account of insider trading, shareholders
systematically lose against informed insiders. However, with CDS trading,
shareholders of the debtor company can emerge as winners where this company
enjoys access to cheaper credit and lower funding costs.
A thorough rethinking of traditional theory is thus required, as well as a more
robust, theoretical account of the efficiency and welfare implications of insider
trading in a world animated by complex derivatives markets. This Article shows
that trading on insider information in CDSs can improve at least the informational,
if not also the allocative efficiency of financial markets in ways traditional
accounts have scarcely anticipated. However, in doing so, CDS markets
reveal that this informational gain can render markets “too” efficient where
they impound new information selectively and with such force that market
stability itself can suffer. Collectively, these observations suggest a need to
revisit the insider trading prohibition itself—and to explore whether consistency
can (and should) factor into supervisory approaches in U.S. equity and derivatives
markets.