Regulation Fair Disclosure and the Cost of Adverse Selection

Abstract

Regulation Fair Disclosure (FD), imposed by the Securities and Exchange Commission in October 2000, was designed to prohibit disclosure of material private information to selected market participants. The informational advantage such select participants gain is unclear. If multiple "insiders" receive identical information, private information is immediately incorporated in price and each insider has zero expected profit. If, on the other hand, Regulation FD has curtailed the flow of information from firms, private information becomes longer-lived and more valuable. Hence, market makers will demand increased compensation by widening the adverse selection component of the bid-ask spread. We identify the cost components of the bid-ask spread for a sample of NASDAQ stocks surrounding the implementation of Regulation FD. Controlling for other factors affecting the spread, we find that adverse selection costs increase approximately 36% after Regulation FD. We interpret our finding as Regulation FD failing to achieve one of its desired objectives.

Regulation fair disclosure and the cost of equity capital

“…For example, Bailey et al (2003) and Irani and Karamanou (2003), among others, find a significant increase in analysts forecast dispersion after Reg FD, although Heflin et al (2003) find no significant changes in analysts forecast dispersion in the post-Reg FD period. In addition, Sidhu et al (2008) find that the adverse selection component of the market makers' bidask spreads is increased after Reg FD for NASDAQ firms, after controlling for other components of the bid-ask spreads. Their findings are consistent with an increase in information asymmetry post Reg FD.…”

The probability and magnitude of information events

“…On the other hand, such firms may give preferential access to a small number of analysts, which might ultimately decrease the number of analysts as others recognize their efforts would be at a serious disadvantage. Finally, as pointed out by Sidhu, Smith, and Whaley (2005), simultaneously disclosing private information to a large number of analysts may have the same effect as public disclosure because when many traders share private information they trade very aggressively and the price impact is nearly immediate.…”

Three Essays on Informed Trading

“…Zhao and Chung (2007) and other studies 52 have settled on trade-weighted means as the unit of analysis, and their methods are followed. Stock months are used per Chung et al (2010) and Sidhu, Smith, Whaley, and Willis (2008), as daily analysis may be highly sensitive to biases with tail events occurring.…”