Regulation Fair Disclosure and the Cost of Adverse Selection

Abstract:     
Regulation FD, imposed by the Securities and Exchange Commission in October 2000, was designed to create a level playing field by prohibiting disclosure of material private information to selected market participants, such as financial analysts. Exactly what informational advantage such 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 to the investment public, private information becomes longer-lived and more valuable. Hence, with increased risk in providing immediacy to potentially informed traders, market makers will demand increased compensation by widening the adverse selection component of the bid/ask spread. To test this proposition, we identify the cost components of the bid/ask spread for a sample of NASDAQ stocks in the period surrounding the implementation of Regulation FD. After controlling for other factors affecting the market maker's spread, we find that Regulation FD has led to an increase in adverse selection costs of approximately 36 percent. We interpret our finding as Regulation FD failing to achieve one of its desired objectives.

Keywords: adverse selection, Reg FD, bid/ask spread, private information

JEL Classifications: D23, D82, G12, G13, G14, G38, L22

Working Paper Series