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.

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

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