If market participants are legally restricted from using inside information, market prices cannot impound it. Furthermore, in the absence of differences in information conveyed to different investors, there will be no arbitrage opportunities and securities markets will necessarily be thin. Thus inhibitions on the use of inside information impair both the speed and accuracy of the market.
Of course, the basic inhibition on the use of inside information rests on generally accepted perceptions of fairness and equity. If an insider tips an analyst off to something with important implications for share price, both the tipper and the tippee will have violated these perceptions. The problem is that the SEC has extended insider trading inhibitions to unreasonable and, indeed, counterproductive, lengths.
According to the “mosaic” theory, for example, any item of information that is not material in itself becomes material if, when combined with other information, it changes the analyst’s view of a company. This is true even if such information would have been perceived as unimportant by the average investor and unworthy of publication by news sources. The SEC has further suggested that the use of any information not available in the marketplace should be restricted — regardless of its source. These extensions discourage analysts and other informed investors from serving their function in the marketplace — namely, going out and acquiring information that will improve the accuracy of market prices and the efficiency of the market in allocating capital.