Regulation fair disclosure and the cost of adverse selection

Abstract

Regulation FD, imposed by the Securities and Exchange Commission (SEC) in October 2000, was designed to create a level playing field by prohibiting selective disclosure of material private information to particular groups. Exactly what advantage these groups gain is unclear. If multiple insiders receive identical information, the information is immediately incorporated in price and the expected profit of each insider is zero. Regardless of the SEC’s motivation in imposing Regulation FD, empirical investigation has shown that it has had a chilling effect, with firms now disclosing less information. With less information flow, private information becomes more long-lived and valuable. With increased risk of providing immediacy to informed traders, market makers will demand increased compensation, widening 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 just before and just after the implementation of Regulation FD. The evidence indicates that Regulation FD has led to an increase in the expected cost of the adverse selection component of the spread.