INSIDER TRADING AND THE BID-ASK SPREAD: A CRITICAL EVALUATION OF ADVERSE SELECTION IN

MARKET MAKING STANISLAV DOLGOPOLOV*

In economic, finance, and legal literature, there is a widespread acceptance of the notion that market makers increase the bid-ask spread in response to insider trading, as they consistently lose money by transacting with better-informed insiders. The development of this adverse selection model of market making was treated as proof that insider trading imposes a real cost on securities markets by decreasing liquidity and increasing the corporate cost of capital and was used as a justification for regulation. This Article is a critical review of the adverse selection literature. It discusses the model’s theoretical development, its use in the regulation debates, a summary of the case law on the harm from insider trading to market makers, and empirical research on the link between insider trading and transaction costs. The adverse selection argument is criticized from both theoretical and empirical standpoints: there are limitations to the model due to required assumptions about the role and behavior of market makers’ inventories; different causal links among insider trading, firm size, quality of disclosure, stock price volatility, and the bid-ask spread are possible; the existing empirical studies may confuse various components of the spread; and information asymmetry may actually benefit market makers.

I. INTRODUCTION A. Insider Trading Controversy

The issue of insider trading1 has never disappeared from academic and public policy debates during the past four decades,2 and this practice has _______________________________________________________

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Copyright © 2004, Stanislav Dolgopolov. * Empire Education Corporation (Latham, NY) and the John M. Olin Center for Law and Economics at the University of Michigan Law School (Ann Arbor, MI). The author thanks Henry G. Manne for suggesting the topic and for his guidance and Faith A. Takes for her encouragement. The author also gratefully acknowledges the valuable comments and help of Omri Ben-Shahar, Laura N. Beny, Laurence D. Connor, Vladislav Dolgopolov, Jon Garfinkel, Zohar Goshen, David R. Henderson, David Humphreville, Kjell Henry Knivsflå, Leonard P. Liggio, Edith Livermore, John Moore, John Papadopoulos, Paula Payton, David S. Ruder, Daniel F. Spulber, Michael Trebilcock, and Martin Young, as well as the Atlas Economic Research Foundation, the Earhart Foundation, and the John M. Olin Center for Law and Economics at the University of Michigan Law School. 1 “Insider trading” refers to transactions in company’s securities by corporate insiders (such as executives, directors, large shareholders, and outside persons with privileged access to corporate affairs) or their associates based on information originating

84 CAPITAL UNIVERSITY LAW REVIEW [33:83 attracted a great deal of publicity and near-universal condemnation.3 Recently, and in the wake of the stock market decline and numerous corporate scandals, insider trading, treated as one of the chief symptoms of the business world’s corruption, once again captured public attention.4

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within the firm that would, once publicly disclosed, affect the prices of such securities. The definition of “informed trading” is broader than “insider trading” because the former also includes transactions on the basis of “market” or “outside” information, such as the knowledge of forthcoming market-wide or industry developments, competitors’ strategies and products, or upcoming takeovers by a third party. There are arguments for regulating the use of external information as well: “The traditional fairness and market integrity bases for regulating insider trading are still important to uphold when market information is involved.” Committee on Federal Regulation of Securities, Report of the Task Force on Regulation of Insider Trading, Part I: Regulation Under the Antifraud Provisions of the Securities Exchange Act of 1934, 41 BUS. LAW. 223, 229 (1985). Indeed, the use of such information is, in some instances, covered by federal securities regulations. See John F. Barry III, The Economics of Outside Information and Rule 10b-5, 129 U. PA. L. REV. 1307, 1308-09 (1981). 2 See Paula J. Dalley, From Horse Trading to Insider Trading: The Historical Antecedents of the Insider Trading Debate, 39 WM. & MARY L. REV. 1289 (1998) (discussing earlier controversies pertaining to the duty to disclose in transactions between asymmetrically informed parties). One of the earliest, and unsuccessful, attempts to regulate insider trading on the federal level occurred after the 1912-13 congressional hearings before the Pujo Committee, which concluded that “[t]he scandalous practices of officers and directors in speculating upon inside and advance information as to the action of their corporations may be curtailed if not stopped.” H.R. REP. NO. 62-1593, at 115 (1913). 3 Insider trading is quite different from market manipulation, false disclosure, or direct expropriation of the company’s wealth by corporate insiders, and trading on asymmetric information is common in many other markets. Nevertheless, insider trading seems objectionable for many reasons. First, corporate employees as “agents” owe fiduciary duties to shareholders as their “principals.” Second, “unfairness” results from trading on information obtained as a byproduct of employment or privileged access to corporate affairs. Third, insider trading is objectionable because of the extent of managerial control over the production, disclosure, and access to inside information, which may give rise to arbitrary, costless, and non-transparent wealth transfers from outside investors to managers. Fourth, insider trading may lead to possible conflicts between maximizing insiders’ trading profits and maximizing the firm’s value. These concerns are very much unique to securities markets. See generally Victor Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws, 93 HARV. L. REV. 322 (1979). 4 In fact, one empirical study posits that selling by corporate insiders after the expiration of lockup provisions was one of the most important immediate factors that led to the New Economy market burst. Eli Ofek & Matthew Richardson, DotCom Mania: The Rise and Fall of Internet Stock Prices, 58 J. FIN. 1113, 1131 (2003). While this study does

2004] INSIDER TRADING AND THE BID-ASK SPREAD 85 Academic analysis has considered insider trading from the

perspectives of such diverse disciplines as economics,5 ethics,6 feminist studies,7 and psychology.8 It has been hailed as a mechanism of enhancing stock price accuracy and an efficient compensation scheme for entrepreneurial services,9 a stimulus of producing information at a low cost,10 compensation for undiversified risk for controlling shareholders,11 a reward to blockholders for their monitoring activities,12 a device mitigating agency costs,13 and a mechanism of credible signaling to the market.14 not suggest that insider selling by itself led to the market crash, the implication is that, in many instances, the outside investors, not the insiders, largely absorbed the loss. See also Mark Gimein, You Bought. They Sold., FORTUNE, Sept. 2, 2002, at 64 (documenting massive insider selling in such companies as Enron, Global Crossing, Tyco, and others before the sharp drop in their shares’ prices). 5 See generally HENRY G. MANNE, INSIDER TRADING AND THE STOCK MARKET (1966); Javier Estrada, Insider Trading: Regulation, Securities Markets, and Welfare Under Risk Aversion, 35 Q. REV. ECON. & FIN. 421 (1995); Norman S. Douglas, Insider Trading: The Case Against the “Victimless Crime” Hypothesis, FIN. REV., May 1988, at 127. 6 See generally Gary Lawson, The Ethics of Insider Trading, 11 HARV. J.L. & PUB. POL’Y 727 (1988); Ian B. Lee, Fairness and Insider Trading, 2002 COLUM. BUS. L. REV. 119; Kim Lane Scheppele, “It’s Just Not Right”: The Ethics of Insider Trading, 56 LAW &

CONTEMP. PROBS. 123 (1993). 7 See generally Theresa A. Gabaldon, Assumptions About Relationships Reflected in the Federal Securities Laws, 17 WIS. WOMEN’S L.J. 215 (2002); Judith G. Greenberg, Insider Trading and Family Values, 4 WM. & MARY J. WOMEN & L. 303 (1998). 8 See generally John Dunkelberg & Debra Ragin Jessup, So Then Why Did You Do It?, 29 J. BUS. ETHICS 51 (2001); David E. Terpstra et al., The Influence of Personality and Demographic Variables on Ethical Decisions Related to Insider Trading, 127 J. PSYCHOL. 375 (1993). 9 See MANNE, supra note 5, at 81-90, 131-58 (discussing the “smoothing” effect of insider trading on the stock price and arguing that insider trading constitutes efficient compensation for entrepreneurial services rendered to the corporation). 10 See David D. Haddock & Jonathan R. Macey, Regulation on Demand: A Private Interest Model, with an Application to Insider Trading Regulation, 30 J.L. & ECON. 311, 318 (1987) (arguing that “insiders are the low-cost suppliers of most of the [firm-specific] information that is useful to securities markets”). 11 See Harold Demsetz, Corporate Control, Insider Trading, and Rates of Return, 76 AM. ECON. REV. (PAPERS & PROC.) 313, 315 (1986). 12 See Stephen Thurber, The Insider Trading Compensation Contract as an Inducement to Monitoring by the Institutional Investor, 1 GEO. MASON L. REV. (n.s.) 119, 119 (1994). 13 See Dennis W. Carlton & Daniel R. Fischel, The Regulation of Insider Trading, 35 STAN. L. REV. 857, 870-71 (1983) (discussing how insider trading may align the interests of shareholders and managers).

86 CAPITAL UNIVERSITY LAW REVIEW [33:83 Insider trading has also been condemned on the grounds that it may reduce investor confidence in securities markets,15 create perverse incentives for management,16 constitute a misappropriation of information and wealth,17 interfere with timely disclosure and the flow of information inside firms,18 adversely affect the process of gathering and disseminating information by

14 See id. at 868 (discussing how insider trading “gives the firm an additional method of communicating and controlling information”). 15 See Lawrence M. Ausubel, Insider Trading in a Rational Expectations Economy, 80 AM. ECON. REV. 1022, 1022-23 (1990) (asserting that insider trading deters potential investors from securities markets, as outsiders want to avoid dilution of their investment returns); Louis Loss, The Fiduciary Concept as Applied to Trading by Corporate “Insiders” in the United States, 33 MOD. L. REV. 34, 36 (1970) (arguing that insider trading constitutes a “grievous insult to the market in the sense that the very preservation of any capital market depends on liquidity, which rests in turn on the investor’s confidence that current quotations accurately reflect the objective value of his investment”). 16 See Frank H. Easterbrook, Insider Trading, Secret Agents, Evidentiary Privileges, and the Production of Information, 1981 SUP. CT. REV. 309, 332-33; David Ferber, The Case Against Insider Trading: A Response to Professor Manne, 23 VAND. L. REV. 621, 623 (1970). 17 See ADOLF A. BERLE JR. & GARDINER C. MEANS, THE MODERN CORPORATION AND

PRIVATE PROPERTY 326 (1932) (arguing that inside information “accordingly belongs in equity to the body of shareholders as a whole”); ROBERT CHARLES CLARK, CORPORATE LAW 273-74 (1986) (arguing that “the amount of the value of new developments unilaterally appropriated by the insiders from the outsiders could be an enormous portion of the total”); James D. Cox, Insider Trading and Contracting: A Critical Response to the “Chicago School,” 1986 DUKE L.J. 628, 651 (pointing out that “a firm wishing to consider alternative dispositions of inside information [for profit] could rightly see that such uses must foreclose trading by its managers”). 18 See OLIVER E. WILLIAMSON, CORPORATE CONTROL AND BUSINESS BEHAVIOR: AN

INQUIRY INTO THE EFFECTS OF ORGANIZATION FORM ON ENTERPRISE BEHAVIOR 95 (1970) (arguing that insider trading may lead to “information hoarding”); Robert J. Haft, The Effect of Insider Trading Rules on the Internal Efficiency of the Large Corporation, 80 MICH. L. REV. 1051, 1052 (1982).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 87 outsiders,19 provoke conflicts among groups of shareholders,20 and increase the corporate cost of capital.21

B. New Argument for Regulating Insider Trading The proponents of deregulating insider trading succeeded in attracting

the attention of academia and government agencies to their economics-based methodology. As a result, the emphasis of the pro-regulators has shifted from the issue of fairness to the search for economic costs of insider trading.22 _______________________________________________________

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19 See Michael J. Fishman & Kathleen M. Hagerty, Insider Trading and the Efficiency of Stock Prices, 23 RAND J. ECON. 106, 107 (1992); Naveen Khanna, Why Both Insider Trading and Non-Mandatory Disclosures Should Be Prohibited, 18 MANAGERIAL &

DECISION ECON. 667, 668 (1997). 20 See Oliver Kim, Disagreements Among Shareholders over a Firm’s Disclosure Policy, 48 J. FIN. 747, 748 (1993); Ernst Maug, Insider Trading Legislation and Corporate Governance, 46 EUR. ECON. REV. 1569, 1570 (2002). 21 See David Easley et al., Is Information Risk a Determinant of Asset Returns?, 57 J. FIN. 2185, 2219 (2002); Morris Mendelson, The Economics of Insider Trading Reconsidered, 117 U. PA. L. REV. 470, 477-78 (1969) (reviewing MANNE, supra note 5). 22 Many works concentrate on managerial incentives and consider whether insider trading, on one extreme, constitutes non-transparent rents detrimental to the corporation or, on the other hand, an efficient form of compensation taken into account in determining the total reward package. See Carlton & Fischel, supra note 13, at 870-71; Ronald A. Dye, Inside Trading and Incentives, 57 J. BUS. 295 (1984); Neelam Jain & Leonard J. Mirman, Real and Financial Effects of Insider Trading with Correlated Signals, 16 ECON. THEORY

333, 340 (2000); Ranga Narayanan, Information Production, Insider Trading, and the Role of Managerial Compensation, FIN. REV., Nov. 1999, at 119. The “pro-insider trading” literature posits that allowing managers to trade on inside information is likely to create beneficial incentives for them. See, e.g., MANNE, supra note 5, at 138-39, 150 (inducing managers to pursue innovation and repeatedly generate “good news”); Carlton & Fischel, supra note 13, at 870-72 (encouraging managers to discover and develop valuable information, economize on compensation renegotiation costs, and signal their willingness to pursue risky projects favorable to diversified shareholders); Guochang Zhang, Regulated Managerial Insider Trading as a Mechanism to Facilitate Shareholder Control, 28 J. BUS. FIN. & ACCT. 35, 36 (2001) (inducing managers to provide shareholders with accurate information). Their opponents contend that insider trading may create perverse incentives for managers. See, e.g., STEPHEN M. BAINBRIDGE, CORPORATION LAW AND ECONOMICS 593 (2002) (encouraging managers to publicize information prematurely); CLARK, supra note 17, at 273-74 (unilaterally altering managers’ compensation package agreements); Cox, supra note 17, at 651-52 (increasing managers’ tolerance of bad performance); Boyd Kimball Dyer, Economic Analysis, Insider Trading, and Game Markets, 1992 UTAH L. REV. 1, 21-22 (encouraging managers to spread rumors and devote too much effort to gaining access to information for trading purposes); Easterbrook, supra note 16, at 332

88 CAPITAL UNIVERSITY LAW REVIEW [33:83 One such cost was pointed out by economists—and utilized by legal

academics and regulatory agencies to justify the existence of regulation—when some works in market microstructure23 proposed that insider trading harms market liquidity due to its adverse effect on market makers—specialists or dealers that provide liquidity on an organized exchange or an over-the-counter (OTC) market.24 This was an attempt to satisfy the criterion advanced by Henry G. Manne: “Ultimately the complaint must be that some individuals are being harmed by allowing insider trading. It is not enough simply to say that insider trading is unfair. If it is unfair, it must be unfair to somebody.”25

The argument is that insider trading increases the bid-ask spread—the difference between the market maker’s “sell” and “buy” prices26—thereby

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(encouraging managers to engage in excessively risky projects and increase stock price volatility); Haft, supra note 18, at 1054-55 (discouraging internal information-sharing); Roy A. Schotland, Unsafe at Any Price: A Reply to Manne, Insider Trading and the Stock Market, 53 VA. L. REV. 1425, 1448-50 (1967) (encouraging managers to delay disclosure and engage in market manipulation). See also Darren T. Roulstone, The Relation Between Insider-Trading Restrictions and Executive Compensation, 41 J. ACCT. RES. 525, 548-49 (2001) (offering empirical evidence suggesting that higher potential profits from legal insider trading are associated with lower explicit executive compensation). 23 Market microstructure, as a field of financial economics, studies trading rules and mechanisms, price discovery, and transaction costs. See generally MAUREEN O’HARA, MARKET MICROSTRUCTURE THEORY (1995); LARRY HARRIS, TRADING AND EXCHANGES: MARKET MICROSTRUCTURE FOR PRACTITIONERS (2003); DANIEL F. SPULBER, MARKET

MICROSTRUCTURE: INTERMEDIARIES AND THE THEORY OF THE FIRM (1999); Ananth Madhavan, Market Microstructure: A Survey, 3 J. FIN. MARKETS 205 (2000); Hans R. Stoll, Market Microstructure, in 1A HANDBOOK OF THE ECONOMICS OF FINANCE 553 (George Constantinides et al. eds., 2003). 24 See HARRIS, supra note 23, at 286-91. 25 MANNE, supra note 5, at 93. 26 The bid-ask spread as such does not constitute a “regrettable” friction for securities markets. Rather, it is a compensation for a very important economic service. One of the earliest works on market making noted that “the jobber’s turn [the spread] represents the price paid by the community for the invaluable privilege of close prices and a continuously free market for securities.” F.E. Steele, The ‘Middleman’ in Finance, 5 ECON. J. 424, 431 (1895). There are three basic measures of the bid-ask spread. See Roger D. Huang & Hans R. Stoll, Dealer Versus Auction Markets: A Paired Comparison of Execution Costs on NASDAQ and the NYSE, 41 J. FIN. ECON. 313, 322-28 (1996). See also Mitchell A. Peterson & David Fialkowski, Posted Versus Effective Spreads: Good Prices or Bad Quotes?, 35 J. FIN. ECON. 269 (1994) (discussing the magnitude of the difference between various spread measures). First, the quoted spread is the difference between the bid and ask prices quoted simultaneously. See Huang & Stoll, supra, at 322. Second, the effective spread is the difference between the actual bid and ask prices executed at the same

2004] INSIDER TRADING AND THE BID-ASK SPREAD 89 increasing the costs of transacting. The importance of the spread is that it represents the “price for immediacy”27 and the “cost of trading and the illiquidity of a market.”28

The adverse selection model analyzes interaction of a market maker with informed and uninformed traders.29 Because providers of liquidity, unable to distinguish among types of traders, are always “losing” on trades with better-informed counterparties,30 they must charge everyone a higher bid-ask spread to compensate for their losses31 and still enter into time, as many transactions occur inside the quoted spread. See id. at 324. Finally, the realized spread is the difference between the actual bid and ask prices for trades separated by a specified period of time, which represents a profit or loss of a liquidity provider in the course of transacting at the initial and subsequent prices. See id. at 326-27. In the presence of multiple market makers, the “best” bid-ask spread and quotes are also known as “inside” or “market.” 27 Harold Demsetz, The Cost of Transacting, 82 Q. J. ECON. 33, 35-36. “Predictable immediacy . . . requires that costs be borne by persons who specialize in standing ready and waiting to trade with the incoming orders of those who demand immediate servicing of their orders. The bid-ask spread is the markup that is paid for [that] predictable immediacy.” Id. The role of market makers as providers of immediacy was recognized much earlier because without such intermediaries, “buyers desirous of buying at once, and sellers anxious for immediate realization, would have to make considerable sacrifices in the matter of price [and f]luctuations in prices would thus occur with greater frequency and greater violence, and the element of pure speculation and uncertainty . . . would be still further increased.” Steele, supra note 26, at 431. See also George J. Stigler, Public Regulation of the Securities Markets, 37 J. BUS. 117, 129 n.16 (1964) (finding that the bid-ask spread represents the price paid for “(1) immediate availability of a buyer or seller; (2) the elimination of short run fluctuations in price”). The London “stock jobbers” in the late 18th – early 19th centuries were one of the first historical examples of specialized intermediaries continuously buying and selling securities to profit from the price differential. See S.R. Cope, The Stock Exchange Revisited: A New Look at the Market in Securities in London in the Eighteenth Century, 45 ECONOMICA 1, 5-8 (1978). 28 Stoll, supra note 23, at 562. 29 Informed traders possess material nonpublic “inside” or “outside” information or enjoy superior abilities in data gathering and processing. In contrast, uninformed traders transact to consume or save, to readjust their portfolios, to act on “noise” and diverging expectations, and to make speculative bets. See MANNE, supra note 5, at 84-86; Fischer Black, Noise, 41 J. FIN. 529 (1986). 30 See O’HARA, supra note 23, at 54. 31 See id. A variant of the adverse selection model states that market makers also reduce market liquidity by decreasing the market depth—the amounts of shares offered by a market maker at his bid and ask prices—in order to limit their exposure to the risk of incurring losses while trading with better-informed persons. See infra notes 474-79 and accompanying text.

90 CAPITAL UNIVERSITY LAW REVIEW [33:83 some “adverse” transactions.32 Furthermore, insider trading is said to impose a social loss: securities prices are discounted due to higher transaction costs,33 and some potential investors refrain from participating in such markets.34

Thus, the case for regulating insider trading was alleged: “[Informed] trades can damage the dealer, perhaps fatally. That’s a valid reason for discouraging trading on so-called ‘inside’ information, quite apart from whether such trading entails misappropriation of corporate property or wire fraud.”35 Similarly, a leading legal academic has remarked that “the more that the law successfully prohibits the use of non-public information, the more that the market maker can (and will be forced by competitive pressure to) narrow the bid-ask spread.”36

The adverse selection argument is not concerned with the “unfairness” of trading on inside information or with wealth transfers from uninformed to informed traders.37 Rather, it points out an economic cost of insider _______________________________________________________

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32 See O’HARA, supra note 23, at 54. In the context of market microstructure, an alternative meaning of “adverse selection” refers to the notion that limit orders tend to be executed at times when the market moves against them, leading to transactions that are unfavorable in light of the new market conditions. See David K. Whitcomb, Applied Market Microstructure, J. APPLIED FIN., Fall–Winter 2003, at 77, 78. 33 See infra note 99 and accompanying text. 34 See infra note 91 and accompanying text. 35 Jack L. Treynor, Securities Law and Public Policy, FIN. ANALYSTS J., May–June 1994, at 10, 10. 36 John C. Coffee, Jr., Is Selective Disclosure Now Lawful?, N.Y. L.J., July 31, 1997, at 5. 37 The wealth redistribution argument states that trading on asymmetric information is a zero-sum game. But the fact of insider trading does not induce most individual transactions of outsiders with insiders. See Henry G. Manne, Insider Trading and the Law Professors, 23 VAND. L. REV. 547, 551-53 (1970); Jack M. Whitney II, Section 10b-5: From Cady, Roberts to Texas Gulf: Matters of Disclosure, 21 BUS. LAW. 193, 201-04 (1965). The U.S. Supreme Court reached a similar situation in Dirks v. SEC, 463 U.S. 646 (1983), which held that “in many cases there may be no clear causal connection between inside trading and outsiders’ losses. In one sense, as market values fluctuate and investors act on inevitably incomplete or incorrect information, there always are winners and losers.” Id. at 667 n.27. Even the U.S. Securities and Exchange Commission (SEC) officials admitted that “[w]ith respect to equities trading, it may well be true that public shareholders’ transactions would have taken place whether or not an insider was unlawfully in the market.” Thomas C. Newkirk & Melissa A. Robertson, Remarks at the Sixteenth International Symposium on Economic Crime (Sept. 19, 1998), available at http://www.sec.gov/news/speech/speecharchive/1998/spch221.htm (last visited Jan. 11, 2005). However, even though an uninformed trader transacting directly with an insider in an impersonal market is unlikely to suffer a loss, compared to a hypothetical with no insider

2004] INSIDER TRADING AND THE BID-ASK SPREAD 91 trading: a higher bid-ask spread and a corresponding decrease in market liquidity. A wealth of empirical evidence is cited in support of this theory. Yet the model does not attempt to describe a general equilibrium in securities markets. Indeed, the argument is quite elegant and simplified, as one would justly expect from an economic model. C. Article’s Scope of Analysis

This Article reviews the adverse selection literature, discussing the development of the model and its utilization by the legal academics and the regulators; the analysis of assumptions concerning market makers’ inventories; comparative analysis of the specialist and dealer systems; detection of informed trading by market makers; the correlation and possible theoretical links among the spread, quality of disclosure, insider trading, rate of return, stock price volatility, trading volume, and firm size; the overall effect of information asymmetry on providers of liquidity; informed trading and market making in derivatives; the relevance of the adverse selection argument to the practices of “cream-skimming” and trading in otherwise identical circumstances, the fact of insider trading induces or preempts some other marginal transaction and thus causes a loss or deprives of a potential gain. See WILLIAM K.S. WANG & MARK STEINBERG, INSIDER TRADING 62-105 (1996) (discussing the “Law of Conservation of Securities”); Henry G. Manne, In Defense of Insider Trading, HARV. BUS. REV., Nov.–Dec. 1966, at 113, 114-15 (arguing that insider trading induces unfavorable transactions of short-term traders—not necessarily those who trade directly with insiders). It should be noted that long-term shareholders are rarely adversely affected by insider trading, as there is a lower chance that trading on private information would affect their trading pattern. See MANNE, supra note 5, at 102, 107. But the same argument is still revived, maintaining that uninformed traders are always disadvantaged: “In bad times, this disadvantage can result in the uninformed trader’s portfolio holding too much of the stock; in good times, the trader’s portfolio has too little . . . . Holding many stocks cannot remove this effect because the uninformed do not know the proper weights of each asset to hold.” Easley et al., supra note 21, at 2218-19. However, the described harm comes not from insider trading, but from the lack of instantaneous disclosure of all material information, which is likely to be harmful to corporate operations. Insider trading is also likely to redistribute wealth among outsiders, benefiting some of them due to its effect on the market price and trading patterns. See MANNE, supra note 5, at 93-110; WANG &

STEINBERG, supra, at 64. Some argue that even abstaining from trading on inside information would yield abnormal profits. See Jesse M. Fried, Insider Abstention, 113 YALE L.J. 455, 463 n.29, 465 & nn.35-37 (2003) (citing various scholars supporting this point of view). However, others question the validity of this proposition and the magnitude of such profits. See id. at 466-67 (arguing that “the insider’s ability to abstain on nonpublic information indicating that a planned trade would be unfavorable merely compensates the insider for her inability to proceed with a trade after learning nonpublic information indicating that the planned trade would be favorable”).

92 CAPITAL UNIVERSITY LAW REVIEW [33:83 payment for order flow; the relationship between insider trading regulation and market liquidity; and the summary of empirical work on the relationship between insider trading and transaction costs. This Article concludes by evaluating the adverse selection argument as an economic model, considering the elements that control the magnitude of the adverse selection component of the bid-ask spread, and suggesting directions for future empirical research.

II. DEVELOPMENT OF THE ADVERSE SELECTION MODEL A. Genesis of the Idea

The adverse selection model originated in an influential—although only four-page long—article by Jack L. Treynor, a prominent financial researcher and practitioner and one of the co-inventors of the Capital Asset Pricing Model (CAPM).38 D. Jeanne Patterson raised a similar point earlier when she noted a possible harm from insider trading to specialists, as short-term traders, and the maintenance of a continuous market.39 An even earlier law review article also touched on a related theme:

An interesting issue arises when the insider deals with a professional, such as a specialist or, as would invariably be the case in the over-the-counter market, a market maker. . . . [I]t may be contended that [liquidity provider’s] investment decisions to buy and sell are not affected by a nondisclosure of information. Yet, this is clearly unrealistic; if a specialist knew that a company had substantially reduced its dividend, he would accordingly adjust his market.40

_______________________________________________________ 38 Walter Bagehot (pseud. for Jack L. Treynor), The Only Game in Town, FIN. ANALYSTS J., Mar.–Apr. 1971, at 12. For the discussion of Treynor’s role as one of the co-inventors of the CAPM, see Craig W. French, The Treynor Capital Asset Pricing Model, J. INV. MGMT., 2d Quarter 2003, at 60. 39 D. Jeanne Patterson, Insider Trading and the Stock Market, 57 AM. ECON. REV. 971, 973 (1967) (reviewing MANNE, supra note 5). 40 Arthur Fleischer, Jr., Securities Trading and Corporate Information Practices: The Implications of the Texas Gulf Sulphur Proceeding, 51 VA. L. REV. 1271, 1299 n.130 (1965).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 93

B. Subsequent Early Research

Subsequent theoretical research further analyzed the losses of market makers to informed traders. Scholars have noted that, “[w]hile previous studies have emphasized the cost market-makers incur by the employment of their own time and capital, [they] have ignored . . . the potential losses from trading with individuals who possess special information . . . even after the bid-ask spread is included.”41 Dennis E. Logue similarly argued that, when suspecting informed trading, a provider of liquidity would “raise the price of liquidity services and . . . supply less liquidity service,” leading “to the permanent incorporation of a premium against the possibility of information trading.”42

Empirical research seemed to verify theoretical predictions. George J. Benston and Robert L. Hagerman concluded that unsystematic risk, as a proxy for information asymmetry and the intensity of insider trading, is positively related to the bid-ask spread.43 Hans R. Stoll attributed “a tendency for dealers to take inventory losses with respect to the next day’s price changes,” to informed trading and concluded that “losses must be recouped (at the expense of other investors) by setting a wide enough spread.”44 Dale Morse and Neal Ushman documented widening spreads on days characterized by large price changes and theorized that this could be due to trading on private information.45

C. Theoretical Analysis of Adverse Selection in Market Making The adverse selection model was formalized with the publication of

the theoretical contributions summarized below,46 together with the original insight.47

_______________________________________________________

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41 Jeffrey F. Jaffe & Robert L. Winkler, Optimal Speculation Against an Efficient Market, 31 J. FIN. 49, 49 (1976). 42 Dennis E. Logue, Market-Making and the Assessment of Market Efficiency, 30 J. FIN. 115, 120-21 (1975). 43 George J. Benston & Robert L. Hagerman, Determinants of Bid-Asked Spreads in the Over-the-Counter Market, 1 J. FIN. ECON. 353, 362-63 (1974). 44 Hans R. Stoll, Dealer Inventory Behavior: An Empirical Investigation of Nasdaq Stocks, 11 J. FIN. & QUANTITATIVE ANALYSIS 359, 367 (1976). 45 Dale Morse & Neal Ushman, The Effect of Information Announcements on the Market Microstructure, 58 ACCT. REV. 247, 257 (1983). 46 These works were preceded by two studies that modeled the “information cost” due to trading with individuals with superior information as one of the expenses of providing liquidity. See Stoll, supra note 44; Hans R. Stoll, The Supply of Dealer Services in Securities Markets, 33 J. FIN. 1133 (1978). One law review article published at that time also discussed the harm to market makers from insider trading, but did not mention that

94 CAPITAL UNIVERSITY LAW REVIEW [33:83 BAGEHOT 197148

• The market maker has “to provide liquidity by stepping in and transacting whenever equal and opposite orders fail to arrive in the market at the same time” and to stand “ready to transact with anyone who comes to the market”;49

• The market maker always loses to informed traders, who “are playing a ‘heads, I win, tails, you lose’ game with the market maker,” but gains on transacting with uninformed traders, unable to distinguish between the two types;50

• Depending on the elasticity of uninformed trading to the size of the spread, the market maker has to increase the bid-ask spread in order to discourage trading on inside information of minor significance and to compensate for losses incurred when trading with insiders at the expense of uninformed traders;51

• The spread depends on “the average rate of flow of new information affecting the value of the asset in question” and “the volume of liquidity-motivated transactions.”52

HIRST 198053

• The market maker (“jobber”) interacts with speculators who have information “affecting the value of a security [before] the rest of the market” and investors who trade “to modify the

widened bid-ask spreads could serve as a compensation for liquidity providers’ losses. See William K.S. Wang, Trading on Material Nonpublic Information on Impersonal Stock Markets: Who is Harmed, and Who Can Sue Whom Under SEC Rule 10b-5?, 54 S. CAL. L. REV. 1217, 1231-40 (1981). 47 The summary partially relies on Christa Klijn, What Determines the Bid-Ask Spread? An Introduction to Micro Structure Economics Concerning Trading Mechanisms 11-13 (Feb. 26, 2001) (unpublished manuscript, on file with author). 48 Bagehot, supra note 38. 49 Id. at 13. 50 Id. 51 Id. at 13-14. 52 Id. at 13. 53 I.R.C. Hirst, A Model of Market-Making with Imperfect Information, 1 MANAGERIAL & DECISION ECON. 12 (1980).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 95 liquidity or risk of [their] portfolios [and take] no view on whether a security is underpriced or overpriced”;54

• The market maker possesses only public information, has no operating expenses, and earns no economic profits due to competition;55

• The market maker “has to recognize any loss he has made either by selling to the speculator at a price that was too low or buying from him at a price which, in the light of fuller information, proved to be too high”;56

• Setting a higher bid-ask spread would decrease the speculator’s gain or discourage him from trading;57

• “The immediate burden of paying the speculator his winnings falls on the jobber [because, t]hrough the spread, he recoups this amount from investors”;58

• The jobber may “revise his central price when an announcement of a potential customer’s decision is made,” as this possibly conveys speculators’ information;59

• The spread is determined by “the total transaction frequency,” “the superiority of information possessed by the speculator,” and the investors’ willingness to pay for transactions.60

COPELAND AND GALAI 198361

• The market maker deals with two types of traders: “those possessing special information and liquidity-motivated traders”;62

_______________________________________________________ 54 Id. at 12. 55 Id. 56 Id. at 13. 57 Id. 58 Id. at 15. 59 Id. at 16. 60 Id. at 15. 61 Thomas E. Copeland & Dan Galai, Information Effects on the Bid-Ask Spread, 38 J. FIN. 1457 (1983). 62 Id. at 1458.

96 CAPITAL UNIVERSITY LAW REVIEW [33:83 • “Because traders with special information have the option of

not trading with the dealer, he will never gain from them. He can only lose”;63

• The determination of the bid-ask spread is “a tradeoff between expected losses to informed traders and expected gains from liquidity traders”;64

• “After each trade any private information becomes public”;65

• If the marker maker is a monopolist, he will set the spread that would maximize his revenues; if he has competitors, then the revenues would be close to zero;66

• The spread is determined by the probability of informed trading, competition in market making, elasticity of uninformed trading with respect to the spread, trading volume, and the security’s price volatility.67

GLOSTEN AND MILGROM 198568

• “The problem of matching buyers with sellers” is examined in the context of market making in shares of small companies with low trading volume, more frequent order imbalances, and a relatively large probability of insider trading;69

• The “risk-neutral competitive specialist” recoups the losses due to trading with informed traders by increasing the spread at the expense of liquidity traders;70

• “[A] bid-ask spread can be a purely informational phenomenon, occurring even when all the specialist’s fixed and variable transaction costs (including his time, inventory

_______________________________________________________ 63 Id. 64 Id. 65 Id. at 1459. 66 Id. at 1462. 67 Id. at 1468. 68 Lawrence R. Glosten & Paul R. Milgrom, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, 14 J. FIN. ECON. 71 (1985). 69 Id. at 71. 70 Id. at 72.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 97 costs, etc.) are zero and when competition forces the specialist’s profit to zero”;71

• “[T]he value expectations of the specialist and the insiders tend to converge”;72

• In some circumstances, the market would shut down because “if the insiders are too numerous or their information is too good relative to the elasticity of liquidity traders’ supplies and demands, there will be no bid and ask prices at which trading can occur and the specialist can break even”;73

• The problem of market breakdowns can be resolved by granting the specialist “some monopoly power” to allow him to average trading profits and losses over time;74

• The specialist updates his expectations about the security’s true value by observing the trading patterns; information is not revealed immediately after an insider’s trade;75

• The bid-ask spread depends on the quality of inside information, “the ratio of informed to uninformed” traders, and “the elasticity of uninformed supply and demand”;76

• The adverse selection model may explain “the small firm effect and the ignored firm effect.”77

_______________________________________________________ 71 Id. 72 Id. at 74. 73 Id. 74 Id. at 75. 75 Id. at 80. 76 Id. at 89. 77 Id. at 75. The “small firm effect” and the “ignored firm effect” refer to the phenomena of seemingly abnormally high returns for corporations with small capitalization or little market coverage (which are usually the same ones) in the context of the CAPM. In other words, firm size has a predictive power to estimate expected returns that are not captured by the correlation between the market’s and the individual security’s returns. For the empirical examination of the firm size factor, see Eugene F. Fama & Kenneth R. French, The Cross-Section of Expected Stock Returns, 47 J. FIN. 427 (1992); Eugene F. Fama & Kenneth R. French, Size and Book-to-Market Factors in Earnings and Returns, 50 J. FIN. 131 (1995).

98 CAPITAL UNIVERSITY LAW REVIEW [33:83

KYLE 198578

• Three types of transactors are present: “a single insider who has unique access to a private observation of the ex post liquidation value of the risky asset; uninformed noise traders who trade randomly; and market makers”;79

• Market makers cannot distinguish between traders, and “the noise traders in effect provide camouflage which enables the insider to make profits at their expense”;80

• Due to insiders’ transactions, their “private information is incorporated into prices gradually”;81

• The market makers earn zero economic profits;82

• Insider trading adversely affects market liquidity through a lower market depth and increased volatility, as random shocks may be interpreted as an indication of insiders trading on private information;83

• The model is “a rigorous version of the intuitive story told by Bagehot.”84

D. Further Implications of the Model

The essence of the adverse selection model is that because of order imbalances and the difficulty of sustaining a liquid market only with matching, a liquidity provider has to transact with his own inventory and thus bears the risk of consistently buying “high” from and selling “low” to insiders.85 At the same time, the theoretical magnitude of the adverse

_______________________________________________________

(continued)

78 Albert S. Kyle, Continuous Auctions and Insider Trading, 53 ECONOMETRICA 1315 (1985). 79 Id. at 1315. 80 Id. at 1316. 81 Id. 82 Id. 83 Id. at 1324. 84 Id. at 1317. 85 See Merton H. Miller & Charles W. Upton, Strategies for Capital Market Structure and Regulation, in MERTON H. MILLER, FINANCIAL INNOVATIONS AND MARKET

2004] INSIDER TRADING AND THE BID-ASK SPREAD 99 selection risk depends on the fraction of total trades executed with the market maker’s inventory.86 Furthermore, for a liquidity provider, compared to other uninformed traders, dealing with informed insiders is allegedly more injurious: “Because specialists and market-makers trade so frequently, they may be disproportionately harmed by insider trading . . . .”87 A liquidity provider must be “maintaining a continuous two-sided market,”88 while other uninformed traders may be trading in the same direction with insiders and are unlikely to transact in the same stock frequently. If insider trading occurs in most stocks, market makers cannot diversify the risk of trading with informed insiders.89

Hence, insider trading arguably forces market makers to increase the bid-ask spread, balancing between their losses to insiders and the exit of some uninformed traders caused by a higher transaction cost.90 A larger spread may also discourage trading on information of minor significance: “A dealer must select a bid-ask spread wide enough to limit the number of trades with customers possessing superior information, but narrow enough to attract an adequate number of liquidity-motivated transactions.”91 Furthermore, “[i]n extreme cases, a market might even undergo a ‘death spiral’; the wider spreads drive away liquidity traders, causing spreads to VOLATILITY 127, 142 (1991) (“The market maker’s main service, in fact, is precisely to bear [the] price risk during the interval between the arrival of customers.”). 86 For instance, one empirical study estimated the portion of total trades executed with the NYSE specialists’ inventory at 11%. George Sofianos & Ingrid M. Werner, The Trades of NYSE Floor Brokers, 3 J. FIN. MARKETS 139, 152 (2000). 87 William K.S. Wang, Selective Disclosure by Issuers, Its Legality and Ex Ante Harm: Some Observations in Response to Professor Fox, 42 VA. J. INT’L L. 869, 882 (2002). 88 Jonathan R. Macey, Securities Trading: A Contractual Perspective, 50 CASE W. RES. L. REV. 269, 278 (1999). See also BERNHARD BERGMANS, INSIDE INFORMATION AND

SECURITIES TRADING: A LEGAL AND ECONOMIC ANALYSIS OF THE FOUNDATIONS OF

LIABILITY IN THE U.S.A. AND THE EUROPEAN COMMUNITY 128 (1991) (noting that “specialists and market makers committed to trade the other side of unmatched transactions . . . . are the only ones who are really ‘caused’ to trade [with insiders] even in the absence of inducing price effects”). 89 The reason is that making market in multiple stocks is unlikely to reduce the average probability of dealing with insiders or cancel out insiders’ transactions. 90 See BERGMANS, supra note 88, at 109-10. 91 WILLIAM F. SHARPE & GORDON J. ALEXANDER, INVESTMENTS 45 (4th ed. 1990). At the same time, the exit of some uninformed traders, due to a greater transaction cost, may benefit the market maker as “[w]idening the bid-ask spread reduces the fraction of expected volume originating from noise traders, thereby making the observed order flow more informative.” J. Chris Leach & Ananth N. Madhavan, Price Experimentation and Security Market Structure, 6 REV. FIN. STUD. 375, 376 (1993).

100 CAPITAL UNIVERSITY LAW REVIEW [33:83 widen further, eventually leaving only the information traders and no way for the market makers to make a living.”92 It was also suggested that, if insider trading is effectively prohibited, “decreased transactions costs will be shared between market makers and outsiders [depending] on the relative elasticities of the supply of and the demand for brokerage services.”93

One of the standard assumptions of the adverse selection model is that a market maker cannot distinguish between informed and uninformed traders.94 Yet, Henry G. Manne poses the following hypothetical: “[I]f the specialist is ‘signaled’ that insiders are in the market, then, in an unregulated regime, he could refuse to engage in those transactions and . . . not lose anything because of insiders’ presence.”95 However, it may be difficult, ex ante, to distinguish between informed and uninformed traders, and the very fact of a refusal to deal with someone may be detrimental to maintaining an orderly market. Similarly, A.C. Pritchard argued that “passive investors may be able to improve their terms of trade relative to the quoted bid/ask spread by credibly communicating their lack of private information”96 and thus allow market makers to price-discriminate, but this is also problematic and may entail additional transaction costs.97

E. Alleged Harm to Liquidity and the Significance of Transaction Costs The harm to the market from insider trading is said to be in higher

transaction costs, borne primarily by uninformed traders who, unlike insiders, do not make abnormal trading profits.98 Furthermore, a greater bid-ask spread is likely to have an adverse effect on the security’s liquidity, _______________________________________________________ 92 Miller & Upton, supra note 85, at 156. For similar scenarios of a possible market breakdown, see O’HARA, supra note 23, at 65, 181; Lawrence R. Glosten, Insider Trading, Liquidity, and the Role of the Monopolist Specialist, 62 J. BUS. 211, 212 (1989); Hans R. Stoll, Alternative Views of Market Making, in MARKET MAKING AND THE CHANGING

STRUCTURE OF THE SECURITIES INDUSTRY 67, 78 (Yakov Amihud et al. eds., 1985). See also George A. Akerlof, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 Q. J. ECON. 488 (1970) (describing a general problem of market breakdowns caused by asymmetric information). 93 David D. Haddock & Jonathan R. Macey, A Coasian Model of Insider Trading, 80 NW. U. L. REV. 1449, 1457 (1986). 94 See Bagehot, supra note 38, at 13. 95 Henry G. Manne, Insider Trading: Risk Premiums and Confidence Games 16-17 (Sept. 28, 1995) (unpublished manuscript, on file with author). 96 A.C. Pritchard, Markets as Monitors: A Proposal to Replace Class Actions with Exchanges as Securities Fraud Enforcers, 85 VA. L. REV. 925, 972 n.192 (1999). 97 Id. 98 See NASSER ARSHADI & THOMAS H. EYSSELL, THE LAW AND FINANCE OF

CORPORATE INSIDER TRADING: THEORY AND EVIDENCE 65-66 (1993) (reviewing empirical research on insiders’ abnormal gains).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 101 the firm’s cost of capital, and its stock price.99 Hence, insider trading, in addition to transferring wealth from the uninformed to the informed, allegedly imposes a social loss in the form of decreased investment and lower firm value.

However, liquidity in securities markets is sometimes questioned as inherently beneficial to the society at large.100 There is corresponding skepticism that lower transaction costs would yield a social benefit.101 One might also recall John Maynard Keynes as stating: “Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity . . . .”102 Arguably, a higher transaction cost may benefit society by discouraging some “wasteful” short-term investing and speculation.103 _______________________________________________________

(continued)

99 See Yakov Amihud & Haim Mendelson, Asset Pricing and the Bid-Ask Spread, 17 J. FIN. ECON. 223, 223-24 (1986). See also Yakov Amihud & Haim Mendelson, Liquidity and Asset Prices: Financial Management Implications, FIN. MGMT., Spring 1988, at 5, 6 [hereinafter Amihud & Mendelson, Liquidity and Asset Prices] (arguing that even a small decrease in the transaction cost of a frequently traded asset may drastically increase its value). The relationship between liquidity / transaction costs and stock returns has been extensively documented in the empirical literature. See Yakov Amihud, Illiquidity and Stock Returns: Cross-Section and Time-Series Effects, 5 J. FIN. MARKETS 31 (2002); Yakov Amihud & Haim Mendelson, The Effects of Beta, Bid-Ask Spread, Residual Risk, and Size on Stock Returns, 44 J. FIN. 479 (1989); Michael J. Brennan & Avanidhar Subrahmanyam, Market Microstructure and Asset Pricing: On the Compensation for Illiquidity in Stock Returns, 41 J. FIN. ECON. 441 (1996); Vinay T. Datar et al., Liquidity and Stock Returns: An Alternative Test, 1 J. FIN. MARKETS 203 (1998); Venkat R. Eleswarapu, Cost of Transacting and Expected Returns in the Nasdaq Market, 52 J. FIN. 2113 (1997). However, there is theoretical and empirical research indicating that, in some instances, the primary effect of transaction costs is reflected in the duration of the average holding period of an asset instead of its price and rate of return. See Allen B. Atkins & Edward A. Dyl, Transactions Costs and Holding Periods for Common Stocks, 52 J. FIN. 309 (1997); Michael J. Barclay et al., The Effects of Transaction Costs on Stock Prices and Trading Volume, 7 J. FIN. INTERMEDIATION 130 (1998); George M. Constantinides, Capital Market Equilibrium with Transaction Costs, 94 J. POL. ECON. 842 (1986); Dimitri Vayanos, Transaction Costs and Asset Prices: A Dynamic Equilibrium Model, 11 REV. FIN. STUD. 1 (1998). 100 See Lynn A. Stout, Are Stock Markets Costly Casinos? Disagreement, Market Failure, and Securities Regulation, 81 VA. L. REV. 611 (1995). 101 See Lynn A. Stout, Technology, Transactions Costs, and Investor Welfare: Is a Motley Fool Born Every Minute?, 75 WASH. U. L. Q. 791, 810 (1997). 102 JOHN MAYNARD KEYNES, THE GENERAL THEORY OF EMPLOYMENT, INTEREST, AND

MONEY 155 (1936). 103 Several prominent academics advocate a securities transaction tax on the same grounds. See, e.g., Joseph E. Stiglitz, Using Tax Policy to Curb Speculative Short-Term Trading, 3 J. FIN. SERVICES RES. 101 (1989); Lawrence H. Summers & Victoria P. Summers, When Financial Markets Work too Well: A Cautious Case for a Securities

102 CAPITAL UNIVERSITY LAW REVIEW [33:83 Keynes himself suggested that higher bid-ask spreads, along with brokerage fees and securities transfer taxes, tend to curb speculative activities in the equity market.104

Indeed, an implication of higher spreads could be that investors increase the average holding period of securities in their portfolios. For instance, one study examined listing switches from the NASDAQ to the NYSE and AMEX and found that higher spreads “significantly reduce trading volume, but do not have a significant effect on prices.”105 However, the desirability of limiting liquidity is debatable. Even though “noise” traders and speculators may be responsible for excessive volatility and social loss due to devoting resources to non-productive activities in the secondary market, they possibly play an important role by injecting capital into the equity market as a whole and subsidizing the price discovery process.106

Transactions Tax, 3 J. FIN. SERVICES. RES. 261 (1989). For a criticism of the securities transaction tax proposal, see Allen B. Atkins & Edward A. Dyl, Stock Price Volatility, Transactions Costs and Securities Transactions Taxes, 18 MANAGERIAL & DECISION ECON. 709 (1997); Joseph A. Grundfest & John B. Shoven, Adverse Implications of a Securities Transactions Excise Tax, 6 J. ACCT. AUDITING & FIN. (n.s.) 409 (1991); Paul H. Kupiec, A Securities Transaction Tax and Capital Market Efficiency, 13 CONTEMP. ECON. POL’Y 101 (1995); Steven R. Umlauf, Transaction Taxes and the Behavior of the Swedish Stock Market, 33 J. FIN. ECON. 227 (1993). But see G. William Schwert & Paul J. Seguin, Securities Transactions Taxes: An Overview of Costs, Benefits and Unresolved Questions, FIN. ANALYSTS J., Sept.–Oct. 1993, at 27, 32 (criticizing the idea of a securities transaction tax on the grounds that it would deter a portion of uninformed trades and thus increase the adverse selection cost for market makers). 104 See KEYNES, supra note 102, at 159-60. See also Wang, supra note 87, at 883 (discussing the proposition that “[i]f insider trading increases bid-ask spreads and disproportionately harms frequent traders, the country arguably might benefit because of the deterrence of excessive stock trading and speculation”). 105 Barclay et al., supra note 99, at 130. 106 Scholars have also pointed to other benefits of having liquid securities markets. See, e.g., Black, supra note 29, at 531 (asserting that liquidity encourages acquisition of information due to better opportunities for profiting on it); Paul G. Mahoney, Is There a Cure for “Excessive” Trading?, 81 VA. L. REV. 713, 735-36 (1995) (claiming that liquidity benefits the market for corporate control); Ernst Maug, Large Shareholders as Monitors: Is There a Trade-Off Between Liquidity and Control?, 53 J. FIN. 65, 89 (1998) (arguing that liquidity creates beneficial incentives for blockholders). However, liquidity may have adverse consequences for outside investor monitoring and thus increase agency costs. See Amar Bhide, The Hidden Costs of Stock Market Liquidity, 34 J. FIN. ECON. 31 (1993).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 103

III. ACCEPTANCE AND USE OF THE ADVERSE SELECTION ARGUMENT A. Utilization of the Argument in Legal Literature

Legal literature utilized the adverse selection model to point out the costs of insider trading and to justify its regulation.107 Among legal

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(continued)

107 Many legal publications, including those by the proponents of deregulating insider trading, mentioned the adverse selection concern. See, e.g., BAINBRIDGE, supra note 22, at 585-86; BERGMANS, supra note 88, at 109-10, 128; MICHAEL P. DOOLEY, FUNDAMENTALS OF CORPORATION LAW 855-56 (1995); JONATHAN R. MACEY, INSIDER

TRADING: ECONOMICS, POLITICS, AND POLICY 14 (1991); ROBERTA ROMANO, THE GENIUS OF

AMERICAN CORPORATE LAW 105 & n.50 (1993); WANG & STEINBERG, supra note 37, at 82; Michael Abramowicz, Cyberadjudication, 86 IOWA L. REV. 533, 562 n.71, 579 n.137 (2001); Yakov Amihud & Haim Mendelson, A New Approach to the Regulation of Trading Across Securities Markets, 71 N.Y.U. L. REV. 1411, 1427 & n.97 (1996); Ian Ayres & Joe Bankman, Substitutes for Insider Trading, 54 STAN. L. REV. 235, 276 (2001); Ian Ayres & Stephen Choi, Internalizing Outsider Trading, 101 MICH. L. REV. 313, 321, 334-35 & n.68, 351, 370, 394 (2002); Brad M. Barber et al., The Fraud-On-The-Market Theory and the Indicators of Common Stocks’ Efficiency, 19 J. CORP. L. 285, 291-92 & n.44 (1994); Christopher J. Bebel, A Detailed Analysis of United States v. O’Hagan: Onward Through the Evolution of the Federal Securities Laws, 59 LA. L. REV. 1, 59 n.249 (1998); Laura Nyantung Beny, U.S. Secondary Stock Markets: A Survey of Current Regulatory and Structural Issues and a Reform Proposal to Enhance Competition, 2002 COLUM. BUS. L. REV. 399, 431-33, 438-41; Mark Borrelli, Market Making in the Electronic Age, 32 LOY. U. CHI. L. J. 815, 889 (2001); William J. Carney, Signaling and Causation in Insider Trading, 36 CATH. U. L. REV. 863, 888-89 (1987); Stephen J. Choi, Selective Disclosures in the Public Capital Markets, 35 U.C. DAVIS L. REV. 533, 550 & n.75 (2002); John C. Coffee, Jr., The Future as History: The Prospects for Global Convergence in Corporate Governance and Its Implications, 93 NW. U. L. REV. 641, 694 & n.202 (1999); Charles C. Cox & Kevin S. Fogarty, Bases of Insider Trading Law, 49 OHIO ST. L.J. 353, 356 n.11 (1988); Paul Fenn et al., Information Imbalances and the Securities Markets, in EUROPEAN INSIDER DEALING: LAW AND PRACTICE 3, 8, 14 (Klaus J. Hopt & Eddy Wymeersch eds., 1991); Allan Ferrell, A Proposal for Solving the “Payment for Order Flow” Problem, 74 S. CAL. L. REV. 1027, 1055, 1065, 1078-80 & n.197 (2001); Jill E. Fisch, Start Making Sense: An Analysis and Proposal for Insider Trading Regulation, 26 GA. L. REV. 179, 196 n.71 (1991); Merritt B. Fox, Regulation FD and Foreign Issuers: Globalization’s Strains and Opportunities, 41 VA. J. INT’L. L. 653, 671 (2001); Jesse M. Fried, Reducing the Profitability of Corporate Insider Trading Through Pretrading Disclosure, 71 S. CAL. L. REV. 303, 307 n.12 (1998); Nicholas L. Georgakopoulos, Insider Trading as a Transactional Cost: A Market Microstructure Justification and Optimization of Insider Trading Regulation, 26 CONN. L. REV. 1, 18 n.45 (1993); Zohar Goshen & Gideon Parchomovsky, On Insider Trading, Markets, and “Negative” Property Rights in Information, 87 VA. L. REV. 1229, 1251 & nn.84-86, 1252 (2001); Sanford J. Grossman, Merton H. Miller, Kenneth R. Cone, Daniel

104 CAPITAL UNIVERSITY LAW REVIEW [33:83

(continued)

R. Fischel & David J. Ross, Clustering and Competition in Asset Markets, 40 J.L. & ECON. 23, 28, 39 & n.23 (1997); Haddock & Macey, supra note 93, at 1457-58; Haddock & Macey, supra note 10, at 331-32 & n.47; Marilyn F. Johnson et al., In Re Silicon Graphics Inc.: Shareholder Wealth Effects Resulting from the Interpretation of the Private Securities Litigation Reform Act’s Pleading Standard, 73 S. CAL. L. REV. 773, 780 (2000); Marcel Kahan, Securities Laws and the Social Costs of “Inaccurate” Stock Prices, 41 DUKE L.J. 977, 1019 n.185, 1021 n.194 (1992); Mark Klock, Mainstream Economics and the Case for Prohibiting Insider Trading, 10 GA. ST. U. L. REV. 297, 307-08 & nn.69, 74-77 & 79, 328 n.199, 330 nn.210-14 (1994); Mark Klock, The SEC’s New Regulation ATS: Placing the Myth of Market Fragmentation Ahead of Economic Theory and Evidence, 51 FLA. L. REV. 753, 770, 775-77 & nn.183-85 & 190-92, 780, 782-84, 786-88, 791, 793-94 (1999); D. Casey Kobi, Wall Street v. Main Street: The SEC’s New Regulation FD and Its Impact on Market Participants, 77 IND. L.J. 551, 597 (2002); Reinier Kraakman, The Legal Theory of Insider Trading Regulation in the United States, in EUROPEAN INSIDER DEALING: Law AND

PRACTICE 39, 48-49 (Klaus J. Hopt & Eddy Wymeersch eds., 1991); Kimberly D. Krawiec, Fairness, Efficiency, and Insider Trading: Deconstructing the Coin of the Realm in the Information Age, 95 NW. U. L. REV. 443, 443-44 n.4, 468-69 (2001); Donald C. Langevoort, Rereading Cady, Roberts: The Ideology and Practice of Insider Trading Regulation, 99 COLUM. L. REV. 1319, 1324 & n.27 (1999); Lee, supra note 6, at 136-38 & nn.59 & 65, 161 & n.111; Amir N. Licht, Regulatory Arbitrage for Real: International Securities Regulation in a World of Interacting Securities Markets, 38 VA. J. INT’L L. 563, 606-08 (1998); Jonathan R. Macey et al., Restrictions on Short Sales: An Analysis of the Uptick Rule and Its Role in View of the October 1987 Stock Market Crash, 74 CORNELL L. REV. 799, 814 (1989); Macey, supra note 88, at 278-79 & n.32; Paul G. Mahoney, Market Microstructure and Market Efficiency, 28 J. CORP. L. 541, 546-49 & nn.19 & 25 (2003); Lawrence E. Mitchell, Structure as an Independent Variable in Assessing Stock Market Failures, 72 GEO. WASH. L. REV. 547, 567 n.69, 589 n.152 (2004); John G. Moon, The Dangerous Territoriality of American Securities Law: A Proposal for an Integrated Global Securities Market, 21 NW. J. INT’L L. & BUS. 131, 152 (2000); Dale Arthur Oesterle et al., The New York Stock Exchange and Its Out Moded Specialist System: Can the Exchange Innovate to Survive?, 17 J. CORP. L. 223, 233-34, 277 (1992); Karl Shumpei Okamoto, Rereading Section 16(b) of the Securities Exchange Act, 27 GA. L. REV. 183, 214 n.99 (1992); Craig Pirrong, Securities Market Macrostructure: Property Rights and the Efficiency of Securities Trading, 18 J.L. ECON. & ORG. 385, 385-92 & n.4, 402, 406 (2002); Saikrishna Prakash, Our Dysfunctional Insider Trading Regime, 99 COLUM. L. REV. 1491, 1500 n.36 (1999); Pritchard, supra note 96, at 943-44 & nn.66 & 70, 971-72 & nn.191-92, 973 & nn.199-200 & 202, 974, 1004 & n.331; A.C. Pritchard, United States v. O’Hagan: Agency Law and Justice Powell’s Legacy for the Law of Insider Trading, 78 B.U. L. REV. 13, 50 & nn.234-35 (1998); Larry E. Ribstein, Federalism and Insider Trading, 6 SUP. CT. ECON. REV. 123, 159, 161-62 & n.203, 165 (1998); Hartmut Schmidt, Insider Regulation and Economic Theory, in EUROPEAN INSIDER DEALING: LAW AND PRACTICE, 21, 25-28 (Klaus J. Hopt & Eddy Wymeersch eds., 1991); Steve Thel, $850,000 in Six Minutes—The Mechanics of Securities Manipulation, 79 CORNELL L. REV. 219, 234 & n.69 (1994); Robert

2004] INSIDER TRADING AND THE BID-ASK SPREAD 105 academics, “[i]t is widely agreed that insider trading diminishes liquidity. This view is based on a theoretical model that suggests that market makers will offset the risk of trading against insiders by increasing the bid-ask spread.”108 One legal commentator described the adverse selection argument as one of “the most plausible stories of investor harm from insider trading.”109 Another stated that “the major [economic] harm in insider trading is its adverse impact on market efficiency [that] can be loosely measured by the width of the bid/asked spread.”110 The adverse selection model also resembled the earlier argument that when insiders are trading, securities markets’ liquidity suffers due to diminished investor confidence.111

(continued)

B. Thompson & Ronald King, Credibility and Information in Securities Markets After Regulation FD, 79 WASH. U. L.Q. 615, 623 (2001); Wang, supra note 87, at 877-78 & nn.56 & 58, 881-84 & n.73, 887-88; Elliott J. Weiss, United States v. O’Hagan: Pragmatism Returns to the Law of Insider Trading, 23 J. CORP. L. 395, 434 (1998); David E. Van Zandt, The Market as a Property Institution: Rules for the Trading of Financial Assets, 32 B.C. L. REV. 967, 982 n.68 (1991); Iman Anabtawi, Note, Toward a Definition of Insider Trading, 41 STAN. L. REV. 377, 396, 397 & nn.77-79, 398-99 (1989); Note, Insider Trading in Junk Bonds, 105 HARV. L. REV. 1720, 1722-25 & nn.23, 28 & 29 (1992); Coffee, supra note 36, at 4-5. 108 Goshen & Parchomovsky, supra note 107, at 1251. Some legal publications also cite empirical evidence against the adverse selection model. See Beny, supra note 107, at 432-33; Ferrell, supra note 107, at 1079 & n.201; Goshen & Parchomovsky, supra note 107, at 1251 n.86; Wang, supra note 87, at 882 n.70. 109 Krawiec, supra note 107, at 467. 110 Coffee, supra note 36, at 4. 111 The “market integrity” or “investor confidence” rationale for prohibiting insider trading suggests that the presence of trading insiders deters a significant portion of potential outside investors. One of the earliest works on the subject stated that insider trading “does more to discourage legitimate investment in corporate shares than almost anything else.” H.L. Wilgus, Purchase of Shares of Corporation by a Director from a Shareholder, 8 MICH. L. REV. 267, 297 (1910). Some articles also offer formal presentations of the “market integrity” concept. See Ausubel, supra note 15; Utpal Bhattacharya & Matthew Spiegel, Insiders, Outsiders, and Market Breakdowns, 4 REV. FIN. STUD. 255 (1991). But, in most cases, outsiders trade with each other and not with insiders. While uninformed traders would prefer not to have traded with counterparties possessing private information, many of them would participate in a market where insiders are present, unless information asymmetries are too severe. In any instance, “the return from investing in stock, even when facing the risk of occasionally being on the wrong end of a trade based upon inside information, might still be superior to the return on other available investments.” Franklin A. Gevurts, The Globalization of Insider Trading Prohibitions, 15 TRANSNAT’L LAW 63, 92 (2002). Outsiders are more likely to incorporate the risk of insider trading into the required

106 CAPITAL UNIVERSITY LAW REVIEW [33:83 B. Utilization of the Argument by the SEC and in Litigation

The SEC also endorsed the adverse selection argument:

Insider trading may also inflict significant economic injury on exchange specialists or market makers [that] provide market liquidity by standing ready to buy or sell for their own accounts in conditions of excess buying or selling demand. This liquidity creates . . . an orderly market which is advantageous to all investors. But exchange specialists and market makers cannot protect themselves from inside traders. Their market making obligations sometimes force them to trade securities with insiders at prices not reflecting the value of the inside information and, as a result, they may incur losses great enough to cause them to go out of business.112

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rate of return and the stock price instead of exiting the market. As one scholar stated, “To the extent that insider trading reduces expected profits to investors in stocks, it will reduce the price of all stocks subject to insider trading, to the level where stocks once again become attractive and competitive investments.” Carney, supra note 107, at 895. But, despite the assertion that individual investors are compensated for insider trading by the price discount, especially if their portfolios are diversified, the overall effect of insider trading on the company’s value and the consequences for the society’s wealth still remain an issue. One empirical study concluded that “it is hard to predict if stiffer or weaker enforcement of current insider trading laws would increase efficiency . . . . Policies designed to reduce costly insider trading may have a detrimental effect on firm value if executives significantly reduce their holdings of their company’s stock.” Robert T. Masson & Ananth Madhavan, Insider Trading and the Value of the Firm, 39 J. INDUS. ECON. 333, 349-50 (1991). But see LAURA NYANTUNG BENY, DO SHAREHOLDERS VALUE INSIDER

TRADING LAWS? EMPIRICAL EVIDENCE (Harvard Law Sch., Ctr. for Law, Econ., and Bus., Discussion Paper No. 345, 2001) (offering empirical evidence that insider trading regulation is positively associated with the firm value in corporations characterized by the separation of ownership and control). 112 Memorandum of the Securities and Exchange Commission in Support of the Insider Trading Sanctions Act of 1984 (Sept. 15, 1983), in H.R. REP. NO. 98-355, at 23 (1983). See also SEC and Insider Trading: Hearing Before the Subcomm. on Oversight and Investigation of the House Comm. on Energy and Commerce, 99th Cong. 49 (1986) [hereinafter SEC and Insider Trading] (statement of John Shad, Chairman, Securities and Exchange Commission) (“To the extent that market makers and specialists increase the spread in bid and asked prices, and take other precautions to avoid being disadvantaged by inside traders, it reduces the efficiency of the markets at the expense of all investors.”); Insider Trading Sanctions and SEC Enforcement Legislation: Hearing on H.R. 559 Before the Subcomm. on Telecomms., Consumer Prot., and Fin. of the House Comm. on Energy

2004] INSIDER TRADING AND THE BID-ASK SPREAD 107 Furthermore, the SEC cited the adverse selection literature to justify its

Regulation Fair Disclosure (Reg FD): “Economic theory and empirical studies have shown that stock market transaction costs increase when certain traders may be aware of material, undisclosed information. A reduction in these costs should make investors more willing to commit their capital.”113

The adverse selection argument even surfaced in the U.S. Supreme Court during the litigation of the seminal case, United States v. O’Hagan,114 even though the Court did not acknowledge the adverse selection argument in the ruling itself. The brief by the North American Securities Administrators’ Association and a group of law professors stated:

[The bid-ask spread is] a measure of the efficiency of the market for a security. While dealers and specialists are the initial victims of those who trade on misappropriated public information, they pass this injury along to public customers through a widened bid-ask spread. . . . Indeed, customers trading other securities will also be injured, because dealers cannot anticipate which securities will be traded by those in possession of material nonpublic information and will consequently widen the bid-ask spread for all securities that may be the subject of such information.115

and Commerce, 98th Cong. 17 (1983) (prepared statement of John Shad, Chairman, Securities and Exchange Commission) (“Market makers and specialists are exposed to substantial losses when trading with persons who possess confidential inside information because they cannot make rational pricing decisions.”). 113 Selective Disclosure and Insider Trading, Exchange Act Release No. 43,154, 65 Fed. Reg. 51,716 (Aug. 15, 2000) (citing Glosten & Milgrom, supra note 68; Itzhak Krinsky & Jason Lee, Earnings Announcements and the Components of the Bid-Ask Spread, 51 J. FIN. 1523 (1996); Kyle, supra note 78; Charles M.C. Lee et al., Spreads, Depths, and the Impact of Earnings Information: An Intraday Analysis, 6 REV. FIN. STUD. 345 (1993)). 114 521 U.S. 642 (1997). 115 Brief of Amici Curiae North American Securities Administrators Association, Inc., and Law Professors in Support of Petitioner at 8-9, United States v. O’Hagan, 521 U.S. 642 (1997) (No. 96-842) [hereinafter O’Hagan brief]. The following legal academics endorsed the brief: Jeffrey D. Bauman, Victor Brudney, John C. Coffee, Jr., James D. Cox, Melvin A. Eisenberg, Jill E. Fisch, Merritt B. Fox, Ronald J. Gilson, Jeffrey N. Gordon, Robert J. Haft, Robert William Hillman, Donald C. Langevoort, Louis Loss, Mark R. Patterson, Joel Seligman, Lynn A. Stout, Steve Thel, Robert B. Thompson, Samuel C. Thompson, Jr., William K.S. Wang, and Elliott J. Weiss.

108 CAPITAL UNIVERSITY LAW REVIEW [33:83 C. Adverse Selection Argument and the Market Making Industry

Surprisingly, there is little evidence that the adverse selection theory was articulated by the market makers themselves.116 The exchanges and trading networks spoke against insider trading and cooperated with the SEC on monitoring such activities,117 but paid little attention to the alleged

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116 In addition to the O’Hagan brief, supra note 115, the very few industry-originated documents utilizing the adverse selection argument include the following: NYSE Research, Comparing Bid-Ask Spreads on the New York Stock Exchange and Nasdaq Immediately Following Nasdaq Decimalization (July 26, 2001) (arguing that trading venues with more informed trading tend to have wider spreads), available at http://www.nyse.com/pdfs/-research_bid_ask.pdf (last visited Jan. 11, 2005); James C. Miller III et al., Market Implications of the Proposed Rule Change by Boston Stock Exchange, Inc., Establishing Boston Options Exchange and Associated Price Improvement Period 5-8 (Sept. 26, 2003) (offering a study commissioned by the CBOE arguing that the proposed trading mechanism of an alternative options exchange would divert the informed order flow to other exchanges and thus increase their bid-ask spreads), available at http://www.sec.gov/rules/sro/bse-200215/srbse200215-278.pdf (last visited Jan. 11, 2005). However, it is likely that the academic research, rather than the practical concerns of market makers, influenced these documents. Yet, Bernard Madoff, the head of Madoff Investment Securities, a “third market” broker-dealer that specializes in small retail orders, voiced some evidence for the harm to dealers from informed trading when he stated, “Don’t be on the opposite side of a 100,000-share trade because anyone trading 100,000 shares knows more than you do.” Carol Vinzant, Do We Need a Stock Exchange?, FORTUNE, Nov. 22, 1999, at 251, 258. On the other hand, this may reflect the general difficulty with handling large blocks. 117 For a discussion of insider trading surveillance by the NYSE, the National Association of Securities Dealers, the AMEX, the Chicago Board Options Exchange, and the Securities Industry Association, as well as their cooperation in creating the Intermarket Surveillance Group, see SEC and Insider Trading, supra note 112, at 73-77. SEC Chairman John Shad stressed that the securities “[i]ndustry cooperation in the deterrence and detection of insider trading provides valuable assistance to the Commission’s enforcement efforts.” Id. at 76. The fact that exchanges and trading networks dominated by the interests of market professionals (broker-dealers, securities analysts, arbitrageurs, institutional investors with their own research capabilities, etc.) made efforts to curb insider trading is logical as “[m]arket professionals are the insiders’ major rivals for insider trading profits, and the professionals receive virtually all their income from stock market trades.” Haddock & Macey, supra note 10, at 314. See also Robert M. Bushman et al., Insider Trading Restrictions and Analysts’ Incentives to Follow Firms, 60 J. FIN. (forthcoming 2005) (discussing empirical cross-country evidence that insider trading regulation is associated with a greater extent of research performed by securities analysts). At the same time, an interesting historic fact is that in 1939, the leading securities exchanges, including the NYSE, approached the U.S. Congress and the SEC and asked to abolish the “short-swing” profit provision—section 16(B) of the Securities Exchange Act of 1934—which

2004] INSIDER TRADING AND THE BID-ASK SPREAD 109 problem of widening spreads. According to one business publication: “[A] spokesman for the [NYSE] Specialists’ Association, which represents the 456 Big Board stock specialists, says insider trading isn’t an issue for its members.”118 This fact certainly casts doubt on the adverse selection argument’s validity. This may be an indication that the magnitude of widening bid-ask spreads is negligible, or that market makers can somehow benefit from observing informed trading.119

Equally surprising is the fact that market professionals, who, as frequent traders, could greatly benefit from lower transaction costs,120 and corporations, which could lower the cost of capital by increasing their

was the only practical remedy against insider trading under the federal securities laws at that time. See Text of Exchanges’ Proposals to SEC, WALL ST. J., Mar. 15, 1939, at 11. 118 Suzanne McGee, Where Have the Inside Traders Gone? Options Markets Are Their New Home, WALL ST. J., Apr. 23, 1997, at C20. The only case known to this author that considered a loss suffered by an equity market maker due to insider trading is DuPont Glore Forgan, Inc. v. Arnold Bernhard & Co., No. 73 Civ. 3071 (HFW), 1978 U.S. Dist. LEXIS 20385 (S.D.N.Y. Mar. 6, 1978). In this case, an OTC market-maker/broker-dealer alleged harm from insider trading in connection with an upcoming earnings announcement. See id. at *2-8. The court found that the “block” transaction in question was arranged non-anonymously and dismissed the case because the information was judged to be immaterial. See id. at *8-21. Yet, there is evidence that insider trading is a problem for options market makers. See generally, e.g., McGee, supra. 119 One phenomenon recently observed on the NASDAQ, before SuperMontage replaced the Small Order Execution System (SOES), the so-called “SOES bandits” controversy, somewhat resembled the adverse selection model. “SOES bandits are professional traders who watch market makers’ quotes in an attempt to exploit the market trends.” Eugene Kandel & Leslie E. Marx, Odd-Eighth Avoidance as a Defense Against SOES Bandits, 51 J. FIN. ECON. 85, 86 (1999). See also Jeffrey H. Harris & Paul H. Schultz, The Trading Profits of SOES Bandits, 50 J. FIN. ECON. 39 (1998). The important difference is that the “bandits” do not act on inside information, but rather make short-term profits as momentum traders, exploiting inflexible quotes. See id. at 39. “Intra-day traders are ‘information traders’ not because their ‘information’ reflects superior analysis of issuer fundamentals, but because they are faster in reacting to new information . . . . Accordingly, market makers can be expected to widen their spreads to compensate for the increased risk.” Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Order Partially Approving Proposed Rule Change Relating to the Small Order Execution System on Pilot Basis, Exchange Act Release No. 33,377, 58 Fed. Reg. 69,419-01 (Dec. 23, 1993). For a debate on the impact of SOES trading on liquidity, see The Impact and Effectiveness of the Small Order Execution System: Hearing Before the Subcomm. on Finance and Hazardous Materials of the House Comm. on Commerce, 105th Cong. (1998). 120 See Haddock & Macey, supra note 93, at 1458; BAINBRIDGE, supra note 22, at 586.

110 CAPITAL UNIVERSITY LAW REVIEW [33:83 shares’ liquidity,121 similarly ignored the adverse selection model. This leaves the SEC as the only key player in securities markets that consistently utilized the argument. This agency is, of course, interested in demonstrating harms of insider trading in order to justify an expansion of its powers and defend its enforcement policies, especially because prosecution in this area has been one of the SEC’s top priorities.122

IV. INVENTORY AND LOSSES TO MARKET MAKERS A. The Nature of Market Makers’ Losses

The discussion of how market makers suffer losses from insider trading is often surprisingly vague. In many instances, it has been simply presumed that liquidity providers lose to informed insiders because of frequently and consistently buying “high” and selling “low.”123 However, market makers’ losses materialize only at the time when the security’s price is revised and not at the time of a transaction with an insider.124 “[I]t is generally the development and disclosure of the new information adverse to [the market maker’s] net position and not the presence of the insider that will cause him to lose money . . . .”125 Very similarly, Maureen O’Hara remarked:

If the new information, however, is not instantly revealed after the [informed] trade, the issue of [market maker’s] losses to the informed is not so easily resolved. Instead, the size of the loss will depend not only on the current bid and ask prices, but also on how quickly those prices reflect the new true value.126

While providers of liquidity frequently face order imbalances, it also should be recognized that:

Market makers are concerned with order imbalances over very short horizons (often less than an hour), and these need not correspond to the creation of new information about the firm or the trading by investors with special knowledge about the firm. Even if information about the

_______________________________________________________ 121 See Amihud & Mendelson, Liquidity and Asset Prices, supra note 99, at 11. 122 See BAINBRIDGE, supra note 22, at 584-85. 123 See Manne, supra note 95, at 13-17. 124 See id. at 14. 125 Id. at 15-16. 126 O’HARA, supra note 23, at 57. See also Treynor, supra note 35, at 10 (recognizing that a liquidity provider loses only when the market price changes “before the dealer can lay the position off”).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 111 firm is one cause for these order flow imbalances, its effects may be miniscule relative to other factors that influence minute-by-minute trading.127

Besides that, informed trading does not necessarily increase the order imbalance at any given time—insiders’ trades may actually reduce the imbalance.

In essence, a market maker suffers losses only due to adverse changes in the market value of his inventory caused by insider trading.128 “[Liquidity provider’s] damage is determined by comparing his or her actual inventory at the time of disclosure with what that inventory would have been in the absence of the insider trade.”129

B. Inventory Management by Market Makers and Its Consequences Providers of liquidity do not passively absorb order imbalances, but

continuously manage their inventories by adjusting the width and the midpoint of the bid-ask spread130 or by selectively initiating orders.131 Such inventory control is not costless, but not prohibitively expensive.132

It often has been theorized that market makers try to maintain some “preferred” level of inventory.133 Amir Barnea noted that “[t]o limit the

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127 Gideon Saar & Lei Yu, Information Asymmetry About the Firm and the Permanent Price Impact of Trades: Is There a Connection? 31-32 (July 2002) (unpublished manuscript, on file with author). 128 See WANG & STEINBERG, supra note 37, at 59. 129 Id. 130 See O’HARA, supra note 23, at 13-52; Thomas S.Y. Ho & Hans R. Stoll, Optimal Dealer Pricing Under Transactions and Return Uncertainty, 9 J. FIN. ECON. 47 (1981). The SEC recognized the phenomenon of inventory management by the NYSE specialists a long time ago. See Report of Special Study of Securities Markets of the Securities and Exchange Commission, H.R. DOC. NO. 95, pt. 2, at 86 (1963) (discussing the practice of adjusting bid and ask prices to liquidate undesired inventory and the tendency of avoiding an overnight position). 131 An empirical study concluded that the NYSE “specialists manage their inventory positions by selectively timing the magnitude and direction of their trading, participating more actively as sellers (buyers) when holding long (short) positions.” Ananth Madhavan & George Sofianos, An Empirical Analysis of NYSE Specialist Trading, 48 J. FIN. ECON. 189, 191 (1998). 132 One study documented relatively high spreads on the CBOE due to difficulties of “rebalancing of the market maker’s portfolio.” Mel Jameson & William Wilhelm, Market Making in the Options Markets and the Costs of Discrete Hedge Rebalancing, 47 J. FIN. 765, 777 (1992). 133 As early as in the mid-19th century, it was observed that a typical market maker on the London Stock Exchange “generally tries to make his account even, to buy as much

112 CAPITAL UNIVERSITY LAW REVIEW [33:83 risk of losses due to new information [and informed trading], specialists may adopt a dynamic pricing policy where the quoted price is a function of the change in their normal (desired) inventories,”134 but it is essential to emphasize that market makers would adopt the same policy even in the absence of informed trading in order to manage their inventory risks. For instance, Mark B. Garman proposed a model where liquidity providers choose quotes that “equate the rates of [their] incoming buy and sell orders”135 and “pursue a policy of relating their prices to their inventories in order to avoid failure: it cannot be the case that they simply respond to temporary fluctuations in demand and supply.”136 Similarly, Yakov Amihud and Haim Mendelson theorized that “the optimal policy [for market makers] implies the existence of a ‘preferred’ inventory position.”137 Another model posits that a liquidity provider “changes prices to adjust his share inventory toward an equilibrium level with additional changes being induced by the incentive to exploit the [limit order] book to earn speculative gains.”138

A consequence of the “preferred” inventory hypothesis is that the adjustment to the “true” price due to disclosure or some other event may have the same effect on the market maker’s inventory, regardless of whether he had been previously dealing with insiders or not. Certainly, this does not mean that the liquidity provider’s inventory would always be exactly at some desired level at the time of a price change, but it does imply that the overall effect of informed trading on his inventory at the

as he sells, or sell as much as he buys.” HENRY KEYSER, THE LAW RELATING TO

TRANSACTIONS ON THE STOCK EXCHANGE 27 (1850). The adverse selection literature did not pay much attention to the “preferred” inventory concept, but it was mentioned in some works. See, e.g., WANG & STEINBERG, supra note 37, at 66; Glosten & Milgrom, supra note 68, at 88-89; Logue, supra note 42, at 116; Wang, supra note 87, at 882. 134 Amir Barnea, Performance Evaluation of New York Stock Exchange Specialists, 9 J. FIN. & QUANTITATIVE ANALYSIS 511, 514 (1974). 135 Mark B. Garman, Market Microstructure, 3 J. FIN. ECON. 257, 265 (1976). 136 Id. at 267. 137 Yakov Amihud & Haim Mendelson, Dealership Market: Market-Making with Inventory, 8 J. FIN. ECON. 31, 32 (1980). 138 Edward Zabel, Competitive Price Adjustment Without Market Clearing, 49 ECONOMETRICA 1201, 1218 (1981). For other theoretical works modeling the relationship between a market maker’s inventory stock and bid and ask prices, see James Bradfield, A Formal Dynamic Model of Market Making, 14 J. FIN. & QUANTITATIVE ANALYSIS 275 (1979); Ercart Mildenstein & Harold Schleef, The Optimal Pricing Policy of a Monopolistic Marketmaker in the Equity Market, 38 J. FIN. 218 (1983); Maureen O’Hara & George S. Oldfield, The Microeconomics of Market Making, 21 J. FIN. & QUANTITATIVE ANALYSIS 361 (1986).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 113 time of a price revision is ambiguous. Essentially, inventory management shifts the loss to other traders:

[A] market-maker could . . . shift the price of a security so that the rate at which investors sell to him is equal to the rate at which they buy from him. Here the profits of a shrewd [i.e., informed] investor are made at the expense of other investors, not at the market-maker’s expense.139

Legal literature has also admitted that liquidity providers “may sometimes pass the injury to other individual investors prior to disclosure by altering prices and thereby readjusting inventory to the level preferred.”140 Thus, the assertion that the market maker always loses to informed traders is not correct.141 While it is true that “the insider trade changes the specialist/market-maker’s inventory,”142 insiders’ transactions do not necessarily push the market maker away from his preferred inventory level, even though such deviations may be beneficial to him from the ex post perspective.143

A market maker can suffer a loss from the insiders’ presence only when his inventory marginally increases at the time of a stock price fall or marginally decreases at the time of a stock price rise.144 This harm is likely to materialize when informed transactions are made shortly before unanticipated events, but liquidity providers’ losses are less likely in circumstances when there is time for inventory readjustment. This would be true when informed transactions are made shortly before unanticipated events, but market makers’ losses are less likely in circumstances when there is time for inventory readjustment.

Handling large information-motivated orders may also be harmful to a liquidity provider,145 exposing him to additional liquidation difficulties and the risk of an adverse price move against his unadjusted inventory _______________________________________________________ 139 Jaffe & Winkler, supra note 41, at 52. 140 Wang, supra note 87, at 882. 141 To the extent insiders’ trades affect the market maker’s inventory and, consequently, lead to different price quotations to adjust it, insider trading induces some trades ultimately unfavorable to outsiders that would not have happened otherwise. See WANG & STEINBERG, supra note 37, at 66-73. 142 Id. at 60. 143 See id. at 60-61. 144 Wang, supra note 87, at 878. One study documented that “[d]ealer inventories tend to increase on days prior to price declines and tend to decrease on days prior to price increases.” Stoll, supra note 44, at 372. This was also cited as the evidence in support of the adverse selection model in Copeland & Galai, supra note 61, at 1468. 145 See Fischer Black & Myron Scholes, From Theory to a New Financial Product, 29 J. FIN. 399, 402 (1974).

114 CAPITAL UNIVERSITY LAW REVIEW [33:83 position.146 It is also true that “the larger the turnover, the easier it is for the [market maker] to make adjustments in his positions.”147 Thus, the adverse selection concern is more problematic for providing liquidity in an infrequently traded security or, generally, in a relatively illiquid market.148 On the other hand, it is more difficult for insiders to conceal an information-based transaction from a market maker in a thin market.

If liquidity providers do maintain a preferred stock of inventory, one would expect to observe its mean reversion over time, and some empirical studies have attempted to verify this claim. Ananth Madhavan and Seymour Smidt examined one NYSE specialist’s inventories in sixteen stocks.149 They found a weak mean reversion trend, assuming constant inventory targets, but documented a much stronger reversion trend if time-varying targets are assumed.150 The study also concluded that the specialist plays a dual role because, “[a]s a dealer, the specialist quotes prices that induce mean reversion toward a target inventory level; as an investor, the specialist chooses a desired long-term inventory based on portfolio considerations, and may periodically revise this target.”151

Joel Hasbrouck and George Sofianos looked at the specialists’ inventories in 138 NYSE stocks and concluded that “short-term variation reflects classic [inventory-management] dealer behavior, while the long-term variation stems from investment holdings.”152 They also confirmed the existence of time-varying targets.153

Other studies documented a strong mean reversion tendency in the dealers’ inventories154 and a practice of interdealer trading to facilitate _______________________________________________________

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146 Id. (discussing reasons why a market maker would want to charge a block trader a higher price for his services). 147 Seha M. Tinic, The Economics of Liquidity Services, 86 Q. J. ECON. 79, 81 (1972). 148 For instance, while discussing bid-ask spreads in “highly active markets,” one study noted that “the adverse-selection problem arises only when a market maker cannot hope to offset a position immediately.” Sanford J. Grossman & Merton H. Miller, Liquidity and Market Structure, 43 J. FIN. 617, 629 (1988). 149 Ananth Madhavan & Seymour Smidt, An Analysis of Changes in Specialist Inventories and Quotations, 48 J. FIN. 1595, 1602 (1993). 150 Id. at 1597. 151 Id. at 1617-18. 152 Joel Hasbrouck & George Sofianos, The Trades of Market Makers: An Empirical Analysis of NYSE Specialists, 48 J. FIN. 1565, 1576 (1993). 153 Id. at 1588. 154 See, e.g., Oliver Hansch et al., Do Inventories Matter in Dealership Markets? Evidence from the London Stock Exchange, 53 J. FIN. 1623 (1998); Andy Snell & Ian Tonks, Determinants of Quote Price Revisions on the London Stock Exchange, 105 ECON. J. 77 (1995); Andy Snell & Ian Tonks, Testing for Asymmetric Information and Inventory Control Effects in Market Maker Behaviour on the London Stock Exchange, 5 J. EMPIRICAL

2004] INSIDER TRADING AND THE BID-ASK SPREAD 115 inventory risk sharing155 on the London Stock Exchange (LSE).156 The fact that spreads for the NASDAQ stocks decline at the trading day’s close has also been interpreted as evidence that the NASDAQ dealers manage their inventory on a daily basis.157 Empirical evidence on inventory management practices also exists for derivatives markets.158 Hence, FIN. 1 (1998) [hereinafter Snell & Tonks, Determinants of Quote Price Revisions on the London Stock Exchange]. 155 See, e.g., Peter C. Reiss & Ingrid M. Werner, Does Risk Sharing Motivate Interdealer Trading?, 53 J. FIN. 1657 (1998). 156 As a measure of the speed of correcting deviations from the market makers’ preferred level of inventory, some of these studies used the average timing needed to reduce the difference between the actual and desired levels of inventory by 50%. See Madhavan & Smidt, supra note 149, at 1597. For the NYSE, this “half-life” figure was estimated at 7.3 trading days. Id. For the LSE, the estimates are lower. See Hansch et al., supra note 154, at 1626 (2.5 trading days); Snell & Tonks, Determinants of Quote Price Revisions on the London Stock Exchange, supra note 154, at 92 (2.5 to 19.8 trading hours). There is evidence that the NYSE specialists are able to adjust their inventory rapidly and even effectively absorb “sudden involuntary shocks to their holdings” within four trading days. Hasbrouck & Sofianos, supra note 152, at 1575-76. Also compare Kenneth A. Kavajecz & Elizabeth R. Odders–White, An Examination of Changes in Specialists’ Posted Price Schedules, 14 REV. FIN. STUD. 681, 695 (2001) (finding little evidence of inventory management by the NYSE specialists on the intraday basis), with MARIOS PANAYIDES, THE

SPECIALIST’S PARTICIPATION IN QUOTED PRICES AND THE NYSE CONTINUITY RULE 37 (Yale Int’l Ctr. for Fin., Working Paper 04-05, 2004) (finding “compelling evidence” that the NYSE specialists actively rebalance their inventory via quote adjustments on a daily basis). The difference between the NYSE and the LSE was attributed to the diverging institutional structures, such as the affirmative obligations of the NYSE specialists. See Oliver Hansch et al., supra note 154, at 1624. For a general discussion of affirmative obligations, see Hans R. Stoll, Reconsidering the Affirmative Obligation of Market Makers, FIN. ANALYSTS J., Sept.–Oct. 1998, at 72. 157 See K.C. Chan et al., Market Structure and the Intraday Pattern of Bid-Ask Spreads for NASDAQ Securities, 68 J. BUS. 35, 58-59 (1995). 158 See, e.g., Steven Manaster & Steven C. Mann, Life in the Pits: Competitive Market Making and Inventory Control, 9 REV. FIN. STUD. 953, 958 (1996) (stating that “daily inventory changes [of market makers’ inventories in futures contracts on the Chicago Mercantile Exchange] are concentrated about zero”); William L. Silber, Marketmaker Behavior in an Auction Market: An Analysis of Scalpers in Futures Markets, 39 J. FIN. 937, 952 (1984) (documenting that providers of liquidity on the New York Futures Exchange hold their position open for less than two minutes); Yiuman Tse, Market Microstructure of FT-SE 100 Index Futures: An Intraday Empirical Analysis, 19 J. FUTURES MARKETS 31, 51 (1999) (stating that “futures traders [on the London International Financial Futures and Options Exchange generally] bear low inventory risk . . . and they find it easy to control inventory”).

116 CAPITAL UNIVERSITY LAW REVIEW [33:83 empirical research does document the mean reversion phenomenon for market makers’ inventories and active inventory management. The fact that providers of liquidity also act as investors may explain why the mean reversion trend is seemingly weak. C. Importance of Observing Informed Order Flow

As investors, liquidity providers may be at a disadvantage compared to insiders, but it is not obvious why market makers should increase the bid-ask spread because it would hardly mitigate or compensate for their investment risk. Besides, such investments may be based on the order flow data that reflects informed trading.159 Liquidity providers are more likely to trade in the same direction with insiders, making abnormal profits on their trades,160 even if the initial insider’s transaction is made with the market maker’s inventory. Generally, it would be quite difficult to prevent a provider of liquidity from profiting on inferred inside information, as he continuously transacts in both directions and manages his inventory. While an integrated securities firm could establish a “Chinese Wall” between its market making and investment banking or research units, a similar arrangement cannot be implemented easily within a market making unit.161 It is even suggested that, under some circumstances, market makers would have an incentive to delay the disclosure of the order flow data in order to profit on inside information.162

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159 See MANNE, supra note 5, at 251-52 n.16; Mervyn King & Ailsa Röell, Insider Trading, 6 ECON. POL’Y 163, 169 (1988); Manne, supra note 95, at 8-9; Oesterle et al., supra note 107, at 233-34. 160 See supra note 159. 161 In some instances, market makers are not subject to insider trading regulation. For example, when in 1964 the scope of the federal securities laws was enlarged to include the OTC market, the securities industry successfully lobbied that the “short-swing” profit rule would not apply to the OTC market makers. This essentially allowed securities firms to retain their representatives on the boards of directors of the companies in which they made markets. See WILLIAM L. CARY, POLITICS AND THE REGULATORY AGENCIES 96-97, 111 (1972); WILLIAM H. PAINTER, FEDERAL REGULATION OF INSIDER TRADING 68-86 (1968). 162 See, e.g., Robert Bloomfield & Maureen O’Hara, Can Transparent Markets Survive?, 55 J. FIN. ECON. 425, 427-28 (2000). However, the market makers’ position-taking profits could also be due to their knowledge of non-fundamental information—the data on the orders that do not convey any information about the company itself. More specifically, liquidity providers may exploit temporary trends and price pressures or “front-run” on the likely price effects of large orders. See Laura Santini, NYSE Probe Brings Out Critics, INVESTMENT DEALERS DIG., Apr. 28, 2003, at 14. This behavior could be aided by a lesser degree of market transparency—limitations on prompt disclosure of past, current, and anticipated transactions and limit orders—as “[o]rder flow information is the lifeblood of market making. . . . [I]t’s like a poker game where the rules are that everybody has to show

2004] INSIDER TRADING AND THE BID-ASK SPREAD 117 An empirical study by Steven Manaster and Steven C. Mann, which

examines futures trading on the Chicago Mercantile Exchange, found that around two-thirds of market makers’ profits come from favorable price movements that increase the market value of their inventory and not from charging the spread via order matching.163 The study concluded that “the market makers are the predominant informed traders.”164

On the other hand, Joel Hasbrouck and George Sofianos estimate that the NYSE specialists’ “profits are almost entirely a consequence of the bid-ask spread.”165 A similar study provides evidence that the NYSE specialists’ overall losses from position-taking are equal to one third of their spread revenues.166 Also, there is evidence that the LSE dealers, on average, lose on price movements.167 This evidence suggests that, in individually their hands to the market maker but they can’t show their hands to each other and they can’t see the market maker’s hand.” Intermarket Frontrunning and Other Financial Market Manipulations: Hearing Before the Senate Comm. on Banking, Hous., and Urban Affairs, 100th Cong. 63 (1988) (statement of R. Steven Wunsch, Vice President, Kidder, Peabody and Co.). See also David C. Porter & Daniel G. Weaver, Post-Trade Transparency on Nasdaq’s National Market System, 50 J. FIN. ECON. 231, 233 (1998) (offering empirical evidence “that market makers choose to delay the reporting of those trades which either contain information about short-term price movements or reflect deviations from implicit quoting conventions”). At the same time, some argue that liquidity providers may benefit from lower market transparency by being protected from liquidating block orders at unfavorable prices or from losses to momentum traders and thus provide more liquidity. Compare John Board & Charles Sutcliffe, The Proof of the Pudding: The Effects of Increased Trade Transparency in the London Stock Exchange, 27 J. BUS. FIN. &

ACCT. 887, 905-06 (2000) (presenting empirical evidence that more prompt order disclosure on the LSE had no adverse effect on liquidity), with Ananth Madhavan et al., Should Securities Markets Be Transparent? 26-27 (Jan. 18, 2000) (unpublished manuscript, on file with author) (offering empirical evidence that the public disclosure of the limit order book on the Toronto Stock Exchange had an adverse impact on liquidity). 163 Steven Manaster & Steven C. Mann, Sources of Market Making Profits: Man Does Not Live by Spread Alone 3-4 (Feb. 1999) (unpublished manuscript, on file with author). 164 Id. at 18. See also Alex Frino & Elvis Jarnecic, An Empirical Analysis of the Supply of Liquidity by Locals in Futures Markets: Evidence from the Sydney Futures Exchange, 8 PAC.-BASIN FIN. J. 443, 443 (2000) (finding evidence that suggests “aggressive trading by locals [liquidity providers] on the basis of a short-lived information advantage” on the Sydney Futures Exchange). 165 Hasbrouck & Sofianos, supra note 152, at 1588. 166 GEORGE SOFIANOS, SPECIALIST GROSS TRADING REVENUES AT THE NEW YORK

STOCK EXCHANGE (NYSE, Working Paper No. 95-01, 1995). 167 See Oliver Hansch et al., Preferencing, Internalization, Best Execution, and Dealer Profits, 54 J. FIN. 1799, 1801-02 (1999).

118 CAPITAL UNIVERSITY LAW REVIEW [33:83 equity markets, liquidity providers’ gains from trading on private fundamental or non-fundamental information are either not very large or offset by their trading losses.168 Nevertheless, this does not prove that market makers’ trading losses are due to the presence of insiders. Such losses may be attributed to the fact that liquidity providers often trade against the trend as buyers or sellers of “last resort” in order to maintain an orderly market.169

D. Summary Unless insider trading induces significant changes in the market

makers’ inventories during price fluctuations foreseen and acted on by insiders, it cannot have much of an effect on the cost of providing liquidity. Inventory management substantially decreases liquidity providers’ losses and the corresponding effect on the spread, if the market for the security is relatively liquid. The hypothetical that a market maker is hurt by the mere existence of information unknown to him is not useful: “Obviously every shareholder would like to have access to more valuable information, just as he would like to have access to more wealth.”170 Besides, providers of liquidity could benefit from observing trades made on inside information.

V. COMPARATIVE MARKET MAKING AND INFORMED TRADING

A. Alternative Trading Mechanisms The comparative analysis of the two basic trading mechanisms, the

dealer and auction markets, has received considerable attention in the adverse selection literature. A dealer (quote-driven) market consists of market makers trading on their accounts, while an auction (order-driven)

_______________________________________________________ 168 Contra JOON CHAE & ALBERT WANG, WHO MAKES MARKETS? DO DEALERS

PROVIDE OR TAKE LIQUIDITY? 4 (MIT Sloan Sch. of Mgmt., Working Paper No. 4434-03, 2003) (finding that the Taiwan Stock Exchange equity dealers “earn significant excess returns that are driven by information profits instead of market-making profits”). 169 See SPECIAL COMM. ON MKT. STRUCTURE, GOVERNANCE AND OWNERSHIP, NYSE, INC., MARKET STRUCTURE REPORT 21 (2000) [hereinafter NYSE, INC., MARKET STRUCTURE

REPORT], available at http://www.nyse.com/pdfs/marketstructure.pdf (last visited Jan. 11, 2005). For instance, in 1999, “[w]hen specialists did trade for their own accounts, 82.8% of those trades were made against the prevailing trend of the market.” Id. 170 Henry G. Manne, Insider Trading and Property Rights in New Information, in ECONOMIC LIBERTIES AND THE JUDICIARY 317, 318 (James A. Dorn & Henry G. Manne eds., 1987).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 119 market matches market and limit orders, typically through a specialist or similar “designated” market maker.171

The New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) are examples of continuous auctions that utilize the specialist system.172 The Chicago Board Options Exchange (CBOE), the AMEX, the Pacific Exchange, and the Philadelphia Stock Exchange also utilize the specialist system to handle equity options.173 In contrast, the NASDAQ and the LSE use multiple dealers that trade on their account, although recent developments also allowed public limit orders to compete with dealers’ quotes.174

An alternative to both the specialist and dealer systems is an open limit order book, such as the Stock Exchange of Hong Kong and the Paris Bourse (Euronext Paris), which are “pure” auction markets that match public limit orders without any economic agent designated as a market maker who deals on his own account.175

_______________________________________________________ 171 See Huang & Stoll, supra note 26, at 313-14. For a thorough analysis of the NYSE specialist system, see HANS R. STOLL, THE STOCK EXCHANGE SPECIALIST SYSTEM: AN ECONOMIC ANALYSIS (Salomon Bros. Ctr. for the Study of Fin. Inst., Monograph Series in Fin. and Econ. 1985-2, 1985); Oesterle et al., supra note 107. 172 See HARRIS, supra note 23, at 495. 173 Id. 174 One pivotal difference between a NYSE specialist and a NASDAQ market maker is that the latter charges the bid-ask spread in every transaction (even if the incoming orders are perfectly matched), while the former charges the spread only on transactions made with his own inventory. See James L. Cochrane et al., The Structure and Regulation of the New York Stock Exchange, 18 J. CORP. L. 57, 59-60 (1992). However, the NYSE specialists, as brokers’ agents, may charge a commission for certain types of matched orders. See HARRIS, supra note 23, at 500. 175 See Lawrence R. Glosten, Is the Electronic Open Limit Order Book Inevitable?, 49 J. FIN. 1127 (1994) (analyzing the theoretical advantages of a limit order matching system); Mahendrarajah Nimalendran & Giovanni Petrella, Do ‘Thinly-Traded’ Stocks Benefit from Specialist Intervention?, 27 J. BANKING & FIN. 1823 (2003) (finding liquidity improvements on the Italian Stock Exchange after the introduction of a specialist system for thinly-traded stocks instead of a limit order matching system); Philip Y. K. Cheng & Martin Young, An Analysis of the Impact of the Introduction of Market Makers to the Japan Securities Dealers Association Quotations (JASDAQ) Market (2002) (unpublished manuscript, on file with author) (finding liquidity improvements on the JASDAQ, the Japanese OTC market, after the introduction of multiple market makers instead of a limit order matching system).

120 CAPITAL UNIVERSITY LAW REVIEW [33:83

B. Features of the Specialist System A typical feature of the specialist system is that there is just one market

maker per stock.176 The NYSE is the most prominent example—even though it had multiple specialists in the past.177 There has been an extensive discussion whether this arrangement is due to the regulatory intervention or to the economies of scale.178 Indeed, there is empirical evidence that the specialist system, as opposed to a trading arrangement with multiple market makers, is more efficient for low-volume securities.179 Some studies also maintained that the number of market makers should be limited in order to maintain a viable market in liquidity services.180

The centralized order flow confers a substantial advantage because “[t]he specialist is at the hub of the market and knows the identity and tendencies of the major repeat traders [and has] significant access to market information and trends.”181 At the same time, the specialist system does not imply monopolistic pricing due to the following competitive pressures: “(1) rivalry for the specialist’s job, (2) competing markets, (3) outsiders who submit limit orders rather than market orders, (4) floor traders who may bypass the specialist by crossing buy and sell orders themselves, and (5) other specialists.”182 After all, the specialist system is a centralized auction where multiple auctioneers may not be desirable.183 _______________________________________________________

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176 See Oesterle et al., supra note 107, at 267; STOLL, supra note 171, at 10. 177 See STOLL, supra note 171, at 10-11. 178 See Oesterle et al., supra note 107, at 243-44. 179 See Robert Neal, A Comparison of Transaction Costs Between Competitive Market Maker and Specialist Market Structures, 65 J. BUS. 317, 319 (1992); Amber Anand & Daniel G. Weaver, The Value of the Specialist: Empirical Evidence from the CBOE 16 (Oct. 26, 2001) (unpublished manuscript, on file with author). 180 See Jurgen Dennert, Price Competition Between Market Makers, 60 REV. ECON. STUD. 735, 747 (1993); Grossman & Miller, supra note 148, at 629. 181 Oesterle et al., supra note 107, at 233. 182 Demsetz, supra note 27, at 43. Theoretically, different stocks are close substitutes. “The shares a firm sells are not unique works of art but abstract rights to an uncertain income stream for which close counterparts exist either directly or indirectly via combinations of assets of various kinds.” Myron S. Scholes, The Market for Securities: Substitution Versus Price Pressure and the Effects of Information on Share Prices, 45 J. BUS. 179, 179 (1972). 183 See R.H. COASE, THE FIRM, THE MARKET, AND THE LAW 9 (1988) (“Economists observing the regulation of the exchanges often assume that they represent an attempt to exercise monopoly power and aim to restrain competition. [But these regulations may] exist in order to reduce the transaction costs and therefore to increase the volume of trade.”); J. Harold Mulherin et al., Prices are Property: The Organization of Financial

2004] INSIDER TRADING AND THE BID-ASK SPREAD 121 In any instance, there is some evidence that the NASDAQ, a dealer market, is not that much different from the NYSE, a specialist-based auction market with “satellite” regional exchanges that handle a portion of trading in NYSE-listed stocks, in terms of having one dominant market maker.184 “[T]he fiction of atomistic dealer markets is just that; for most [NASDAQ] stocks [in the sample], there is a dominant liquidity provider, much as would be the case in a specialist market.”185

A specialist plays the roles of an auction manager, a broker’s agent, and a price stabilizer who smoothes demand by buying low and selling high and trading against the trend when necessary.186 The specialist’s primary role is that of an auctioneer, but he also must deal on his own account to absorb order imbalances.187 NYSE Rule 104 provides the following guidelines for its specialists:

In connection with the maintenance of a fair and orderly market, it is commonly desirable that a member acting as a specialist engage to a reasonable degree under existing circumstances in dealings for his own account when lack of price continuity, lack of depth, or disparity between supply and demand exists or is reasonably to be anticipated.188 Transactions not part of such a course of dealings . . . are not to be effected.189

This NYSE Rule is based on SEC Rule 11b-1, which requires national securities exchanges to restrict “[specialist’s] dealings so far as practicable to those reasonably necessary to permit him to maintain a fair and orderly market or necessary to permit him to act as an odd-lot dealer.”190 Thus,

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Exchanges from a Transaction Cost Perspective, 34 J.L. & ECON. 591, 630-32 (1991) (analyzing the economic rationale for exchanges’ exclusionary practices, such as limiting off-exchange trading and prohibiting free-riding on price quotes). 184 See Katrina Ellis et al., The Making of a Dealer Market: From Entry to Equilibrium in the Trading of Nasdaq Stocks, 57 J. FIN. 2289, 2291 (2002). 185 Id. 186 See STOLL, supra note 171, at 6-10, 35-37. 187 See id. at 7. 188 RULES OF BD. OF DIR., R. 104(.10)(2) (NYSE, Inc. 2003). 189 Id. R. 104(.10)(3). 190 Rules and Regulations Under the Securities Exchange Act of 1934, Adoption of Regulation on Conduct of Specialists, 17 C.F.R. § 240.11b-1(iii) (2004). It is sometimes suggested that NYSE specialists engage in trading on private information inferred from the order flow, exploiting temporary trends and price pressures, “stepping in” between public orders, and “front-running” on the advance knowledge of large transactions. See Santini, supra note 162, at 13-14. This was a concern decades ago: “During the New Deal, the

122 CAPITAL UNIVERSITY LAW REVIEW [33:83 just like a dealer, a specialist transacts on his own account and bears the inventory risk.191 The inventory concerns may be even more pronounced for a specialist than it would be for one of multiple dealers because the former has to absorb all order imbalances by himself and possesses fewer opportunities to diversify his portfolio.192

C. Comparing Different Market Structures from the Adverse Selection Perspective There is a near consensus that the specialist system is more efficient in

uncovering informed trading.193 One of the reasons is that multiple market makers do not observe the complete order flow that allows informed traders to conceal their activities for a longer time by splitting their orders among different liquidity providers.194 Contrasted to a system of multiple dealers, a specialist observes all trading done on the exchange and can make better predictions of the future price changes by seeing the “large picture.”195

propriety of specialists serving both as brokers, with their unique ability to anticipate price trends because of their physical presence on the exchange floor and possession of the specialists’ order books, and dealers . . . had been the single most controversial issue in exchange regulation.” JOEL SELIGMAN, THE TRANSFORMATION OF WALL STREET: A

HISTORY OF THE SECURITIES AND EXCHANGE COMMISSION AND MODERN CORPORATE

FINANCE 335-36 (3d ed. 2003). See also Note, The Downstairs Insider: The Specialist and Rule 10b-5, 42 N.Y.U. L. REV. 695, 697-700 (1967) (discussing the specialist’s ability to profit on his privileged access to corporate affairs, as well as his knowledge of the limit order book and identities of many buyers and sellers). For one of the latest controversies involving the NYSE specialists, see Plaintiff’s Complaint, CalPERS v. NYSE (S.D.N.Y., filed Dec. 15, 2003), available at http://www.cal-pers.org/eipdocs/about/press/news/invest-corp/reforming/lawsuit-nyse-spec-ialist.pdf (last visited Oct. 13, 2004). One of the consequences of this lawsuit was a settlement of almost $242 million. Press Release, Securities and Exchange Commission, Settlement Reached with Five Specialist Firms for Violating Federal Securities Laws and NYSE Regulations, Release No. 2004-42 (Mar. 30, 2004), available at http://www.sec.gov/news/press/2004-42.htm (last visited Jan. 11, 2005). At the same time, empirical research seems to suggest that the NYSE specialists, on average, lose on price movements. See supra notes 165-66, 169 and accompanying text. 191 See STOLL, supra note 171, at 8. 192 John Affleck-Graves et al., Trading Mechanisms and the Components of the Bid-Ask Spread, 49 J. FIN. 1471, 1473-74 (1994). 193 See STOLL, supra note 171, at 41. 194 See Dennert, supra note 180, at 736; Marco Pagano & Ailsa Röell, Transparency and Liquidity: A Comparison of Auction and Dealer Markets with Informed Trading, 51 J. FIN. 579, 586 (1996). 195 See STOLL, supra note 171, at 41.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 123 Empirical research verified that the specialist system is superior to the

dealer system in detecting informed trading.196 Similarly, it was documented that the impact of trades on quote adjustments is more immediate on the NYSE and AMEX than on the NASDAQ.197

The corresponding prediction was that “the more price setters know about the order flow . . . the better they can protect themselves against losses to insiders, allowing them to narrow their spreads; therefore, the implicit bid-ask spread in a transparent auction is tighter than in a less transparent dealer market.”198 A variant of this idea suggested that the specialist system provides more liquidity in the sense that a “monopolistic” market maker can keep trading even in times when he is likely to end up with a net loss because of the insiders’ presence.199 “[T]he monopolist will always keep the market open since he can achieve [a] cross-subsidization of trades. Consequently, in situations in which asymmetric information is perceived to be a significant problem, the monopolist specialist is able to maintain a more liquid market.”200

Indeed, empirical work comparing the NYSE and the NASDAQ as examples of specialist and dealer markets, respectively, generally concluded that spreads are lower for the NYSE, lending some credibility to _______________________________________________________ 196 See Jon A. Garfinkel & M. Nimalendran, Market Structure and Trader Anonymity: An Analysis of Insider Trading, 38 J. FIN. & QUANTITATIVE ANALYSIS 591, 608 (2003); Hans G. Heidle & Robert D. Huang, Information-Based Trading in Dealer and Auction Markets: An Analysis of Exchange Listings, 37 J. FIN. & QUANTITATIVE ANALYSIS 391, 416-17 (2002). 197 Charles M. Jones & Marc L. Lipson, Price Impacts and Quote Adjustment on the NASDAQ and NYSE / AMEX 1 (June 1999) (unpublished manuscript, on file with author). 198 Pagano & Röell, supra note 194, at 597-98. See also Bernard S. Black, Comment, in THE INDUSTRIAL ORGANIZATION AND REGULATION OF THE SECURITIES INDUSTRY 171, 173 (Andrew W. Lo ed., 1996) (arguing that exchanges may be “offering secrecy, in return for higher effective spread”). 199 See Glosten, supra note 92, at 228. 200 Id. at 215. A similar argument maintained that a monopolist market maker is better positioned for price discovery:

Unlike specialists, competing dealers are unwilling to experiment at cost because the external nature of investment in the production of information creates a free-rider problem as other dealers also observe the trading history. Indeed, it is possible that the specialist’s monopolistic position may make future gains from trading with more precise knowledge sufficiently lucrative so that he chooses to keep the market open even though a multiple-dealer system would close the market.

Leach & Madhavan, supra note 91, at 377.

124 CAPITAL UNIVERSITY LAW REVIEW [33:83 the adverse selection model.201 However, there are alternative explanations for this phenomenon: the specialist system is more competitive due to the presence of limit orders;202 dealers’ collusion may hike up bid-ask spreads;203 and, in general, a trading system with one market maker utilizes a superior price discovery mechanism.204 The NASDAQ market makers may even be more informed than the NYSE specialists, as the former may be engaging in more extensive security analysis.205 Several empirical studies have explicitly rejected the adverse selection explanation for the spread differential.206 The NASDAQ’s existence indicates that the _______________________________________________________

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201 See OFFICE OF ECON. ANALYSIS, SEC, REPORT ON THE COMPARISON OF ORDER

EXECUTIONS ACROSS EQUITY MARKET STRUCTURES iii (2001) (positing that “the dealers or other traders who are supplying liquidity on Nasdaq might be forced to charge wider effective spreads to protect themselves against a high proportion of informed trades included in the market orders”), available at http://www.sec.gov/pdf/ordrxmkt.pdf (last visited Jan 11, 2005); Heidle & Huang, supra note 196, at 409. 202 See Harold Demsetz, Limit Orders and the Alleged Nasdaq Collusion, 45 J. FIN. ECON. 91, 91-93 (1997); Kee H. Chung et al., Limit Orders and the Bid-Ask Spread, 53 J. FIN. ECON. 255, 255 (1999) (finding that, on the NYSE, “a large portion of posted bid-ask quotes originates from the limit-order book without direct participation by specialists, and that competition between traders and specialists has a significant impact on the bid-ask spread”); Roger D. Huang & Hans R. Stoll, Tick Size, Bid-Ask Spreads, and Market Structure, 36 J. FIN. & QUANTITATIVE ANALYSIS 503, 505 (2001) (stating that “[t]he principal reason for lower spreads in auction markets is that limit orders narrow spreads in comparison to dealer spreads”). There is evidence that the recent regulatory developments that allowed for competition between the NASDAQ dealers and limit-order traders have led to decreased spreads. See Kee H. Chung & Robert A. Van Ness, Order Handling Rules, Tick Size, and the Intraday Pattern of Bid-Ask Spreads for Nasdaq Stocks, 4 J. FIN. MARKETS 143, 159 (2001). 203 See In re NASDAQ Market-Makers Antitrust Litig., 894 F. Supp. 703, 708 (S.D.N.Y. 1995); Michael J. Barclay, Bid-Ask Spreads and the Avoidance of Odd-Eighth Quotes on Nasdaq: An Examination of Exchange Listings, 45 J. FIN. ECON. 35, 59 (1997); William G. Christie & Paul H. Schultz, Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?, 49 J. FIN. 1813, 1835 (1994); James P. Weston, Competition on the NASDAQ and the Impact of Recent Market Reforms, 55 J. FIN. 2565, 2596-97 (2000). 204 See Leach & Madhavan, supra note 91, at 399-400. 205 See Ji-Chai Lin et al., External Information Costs and the Adverse Selection Problem: A Comparison of NASDAQ and NYSE Stocks, 7 INT’L REV. FIN. ANALYSIS 113, 132-33 (1998). 206 Hendrik Bessembinder & Herbert M. Kaufman, A Comparison of Trade Execution Costs for NYSE and NASDAQ-Listed Stocks, 32 J. FIN. & QUANTITATIVE

ANALYSIS 287, 289 (1997) (“The larger average trading costs on NASDAQ are apparently not attributable to a larger adverse information cost, [as] the average price impact of NASDAQ trades, which measures information content, is generally similar to or smaller

2004] INSIDER TRADING AND THE BID-ASK SPREAD 125 multiple dealer system is viable even for smaller, high-tech firms, where opportunities for informed trading are substantial.

VI. WIDENING SPREADS OR PRICE DISCOVERY? A. Impact of Informed Trading on the Market Price

It is often argued that informed trading pushes the price in the “correct” direction, as opposed to being submerged in random uninformed trading.207 “Central to the analysis of market microstructure is the notion that, in a market with asymmetrically informed agents, trades convey information and therefore cause a persistent impact on the security price.”208 than on the NYSE.”); Huang & Stoll, supra note 26, at 331 (arguing that “the larger quoted and effective spreads in NASDAQ cannot be ascribed to adverse information” because the realized spreads, as a percentage of the effective spreads, are not lower on the NASDAQ compared to the NYSE). 207 The positive effect of insider trading on price accuracy is often used as an argument for deregulation. However, it is not clear whether insider trading or public disclosure is superior for the purposes of making the market price more informative. Some do argue that insider trading, in some instances, may be more appropriate. Compare Carlton & Fischel, supra note 13, at 867-68 (protecting the company’s competitive position by not revealing corporate secrets, sheltering the issuer from legal liability, and entailing less expenses for the firm), and Daniel R. Fischel, Insider Trading and Investment Analysts: An Economic Analysis of Dirks v. Securities and Exchange Commission, 13 HOFSTRA L. REV. 127, 133, 141 (1984) (mitigating the issue of excessive or inaccurate disclosure and making disclosure more credible when trading by corporate insiders is made public), and Kenneth E. Scott, Insider Trading: Rule 10b-5, Disclosure and Corporate Privacy, 9 J. LEGAL STUD. 801, 810-11 (1980) (effective for conveying negative information, as there tends to be a bias of delaying disclosure of bad news), and Henry G. Manne, The Case for Insider Trading, WALL ST. J., Mar. 17, 2003, at A14 (continuously conveying valuable forward-looking information as opposed to historic data mandated by the periodic disclosure rules), with CLARK, supra note 17, at 280 (noting that it is possible to craft a public statement affecting the market price that does not erode the corporation’s competitive position), and Cox, supra note 17, at 646 (indicating that insider trading may be a “noisy” communication device for affecting the market price). Yet a larger concern remains: will the additional price accuracy provided by insider trading in the existing regime of periodic disclosure of historic and prospective information significantly improve the allocation of real resources in the economy or merely transfer wealth from outsiders to insiders? Answering this question, one scholar stated that “[i]t would be far-fetched indeed to argue that the occasional delay of (possibly soft) information for a few weeks will disrupt the allocation of resources.” Klock, supra note 107, at 303. 208 Joel Hasbrouck, Measuring the Information Content of Stock Trades, 46 J. FIN. 179, 179 (1991).

126 CAPITAL UNIVERSITY LAW REVIEW [33:83 Long before the emergence of the field of market microstructure, one

of the earliest attempts to analyze insider trading from the economic perspective noted the possibility that, when insiders trade on private information, “at the time the information is made public the market price of the securities concerned will already be near the price which will prevail after the announcement.”209 Providers of liquidity may decipher, although imprecisely, the price impact of information possessed by insiders by looking at the size, volume, and direction of individual transactions, as well as the identity of a trader.210

There is empirical evidence suggesting that insider trading aids price discovery. One study concluded that “insider trading is associated with immediate price movements and quick price discovery [and] that the stock market detects informed trading and impounds a large proportion of the

_______________________________________________________ 209 FRANK P. SMITH, MANAGEMENT TRADING: STOCK-MARKET PRICES AND PROFITS 5

(1941). 210 However, an informed trader could disguise his activities by spreading transactions among liquidity providers, trading venues, and related markets or across time and thus slow down the price adjustment process. See Pritchard, supra note 107, at 52. “Insider traders, knowing that they have a monopoly over the relevant information, trade strategically, because extracting the full monopoly benefit from their information depends upon concealing their trading.” Id. But the presence of competing insiders may mitigate the monopoly concern because their trading is likely to increase the speed of price adjustment and reduce the total insiders’ profits. Hence, such competition among insiders may also reduce the adverse selection concern and make the order flow more informative. See KJELL HENRY KNIVSFLÅ, INSIDER TRADING REGULATION, COMPETITION, AND THE BID

ASK SPREAD (Found. for Research in Econ. and Bus. Admin., Working Paper No. 65/1993, 1993). Yet, in certain situations, a greater number of informed traders does not necessarily lead to improved price discovery. See O’HARA, supra note 23, at 106-12. Also, such trade-splitting is primarily due to avoiding legal liability under the existing regulation of insider trading. In an unregulated regime, insiders would not be particularly interested in spreading their transactions over time or over markets, unless there is price discrimination for larger orders or a non-anonymous trading mechanism, or if the lack of funds does not allow making a one-time transaction. Order-splitting would jeopardize their trading profits, add to transaction costs, and increase risk exposure. Possibly, in an unregulated regime, the order flow may be more informative, and this arrangement may benefit market makers. “If the informed traders act distinctively, such as buying large volumes, then the specialist will rapidly discover the information and converge to the new price.” Robert F. Engle, The Econometrics of Ultra-High-Frequency Data, 68 ECONOMETRICA 1, 14 (2000). On the other hand, this legal regime could also make liquidity providers’ inventory management more problematic, as informed traders may be inclined to place orders for larger amounts and closer to the time of disclosure.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 127 information . . . before it becomes public.”211 Another study estimated that “[f]or exchange-listed stocks . . . 88.3 percent of the private information that informed traders have at the beginning of each trading day is absorbed in one day for the average stock . . . . For over-the-counter stocks, an average of 85.1 percent of private information is absorbed in one day.”212 However, many non-empirical legal publications have contested the proposition that insider trading corrects stocks prices efficiently.213

If the detection of informed trading is often rapid and promptly corrects the security’s price, does a market maker have sufficient time to adjust his inventory holdings, neutralizing the effect of transacting with insiders? One may argue that price discovery on the basis of order flow would be largely done by the liquidity provider himself, allowing him to trade ahead of most outside investors, possibly even ahead of market professionals performing fundamental analysis.214 “[A]s prices adjust to new information coming into the market, market making traders are able to get into or out of an asset before it reaches its new equilibrium price.”215

B. Price Discovery Process and Market Makers’ Informational Advantages A market maker would rather engage in price discovery than maintain

a higher spread.216 Apart from possible losses to informed traders, it is in the interest of liquidity providers to quote prices that approach the “true” value of securities in order to attract the maximum transaction volume. A _______________________________________________________ 211 Lisa K. Meulbroek, An Empirical Analysis of Illegal Insider Trading, 47 J. FIN. 1661, 1663 (1992). 212 Ji-Chai Lin & Michael S. Rozeff, The Speed of Adjustment of Prices to Private Information: Empirical Tests, 18 J. FIN. RES. 143, 144 (1995). 213 See WANG & STEINBERG, supra note 37, at 28 & nn.43-44. One empirical study also suggested that insider trading does not lead “to more rapid price discovery than do trades by any other investor.” Sugato Chakravarty & John J. McConnell, Does Insider Trading Really Move Stock Prices?, 34 J. FIN. & QUANTITATIVE ANALYSIS 191, 208 (1999). But this is something one would expect in a relatively anonymous market, where the price impact is generated by the order flow—not by the traders’ undisclosed intention to act on superior information. Yet, this illustrates that insider trading is a “noisy” communication device of a security’s price. 214 See Van Zandt, supra note 107, at 1008. 215 Id. at 1008-09. 216 One theoretical model argued that “market makers have the ability and the incentives to undertake costly price discovery by experimenting with prices (‘testing the waters’) to induce statistically more information order flow. This strategy leads to a faster conversion of beliefs and hence more accurate pricing in the future.” J. Chris Leach & Ananth A. Madhavan, Intertemporal Price Discovery by Market Makers: Active Versus Passive Learning, 2 J. FIN. INTERMEDIATION 207, 208 (1992).

128 CAPITAL UNIVERSITY LAW REVIEW [33:83 market maker would be interested in detecting (and, in some instances, even attracting)217 informed trading in general and specific informed trades in order to infer and profit on the future price movements and price-discriminate among traders, as informed transactors would accept a higher transaction fee.218 In fact, one study posited that the NYSE specialists seek nonpublic information known to individual brokers: “The specialist serves the common good by enforcing an informal agreement among brokers to share information . . . .”219

Compared to other outside investors, market makers may also possess more information due to their specific expertise or special relationships with the issuer.220 For instance, some NASDAQ market makers also serve _______________________________________________________

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217 See Raymond M. Brooks et al., Large Price Movements and Short-Lived Changes in Spreads, Volume, and Selling Pressure, 39 Q. REV. ECON. & FIN. 303, 304-05 (1999). “One way [for liquidity providers] to acquire information quickly is to temporarily increase spreads and thereby discourage uninformed or noise trading.” Id. at 305. The study did find that “[m]arket makers temporarily increase the size of the spread to speed up price discovery during periods of higher information asymmetry.” Id. at 315. 218 See Erik Theissen, Trader Anonymity, Price Formation and Liquidity, 7 EUR. FIN. REV. 1, 23-24 (2003). This study provides evidence that the market makers on the Frankfurt Stock Exchange price-discriminate “by quoting a large spread and granting price improvement to traders deemed uninformed” based on order characteristics, although it is attributed to offsetting liquidity providers’ losses to informed traders. Id. Another study suggests that price improvement, as a form of price discrimination, may also be attributed to the market power exercised by some traders, enabling them to negotiate with market makers. See Matthew Rhodes-Kropf, Price Improvement in Dealership Markets, 78 J. BUS. (forthcoming July 2005). 219 Lawrence M. Benveniste et al., What’s Special About the Specialist?, 32 J. FIN. ECON. 61, 66 (1992). The authors argue that this information-sharing leads to a lower bid-ask spread in accordance with the adverse selection model. See also Joachim Grammig et al., Knowing Me, Knowing You: Trader Anonymity and Informed Trading in Parallel Markets, 4 J. FIN. MARKETS 385 (2001) (documenting the correlations between trader anonymity, the estimate of the probability of informed trading, and the bid-ask spread on the Frankfurt Stock Exchange vis-à-vis the electronic trading networks). Yet, the primary effect of information-sharing probably would be reflected primarily in more accurate pricing rather than the bid-ask spread. 220 An explanation for the link between informational advantages enjoyed by a liquidity provider and smaller bid-ask spreads may be outside the adverse selection model. Smaller spreads may be attributed not to the fact that the informational advantage of the corporate insiders over the market maker is to some extent eroded, sheltering the latter from trading losses, but to the fact that the market maker is better informed relative to outside investors, which allows him to provide more accurate pricing or, possibly, cross-subsidize market making with profits made on trading on private information. In other words, market makers’ mere access to superior information is likely to decrease the spread even in the

2004] INSIDER TRADING AND THE BID-ASK SPREAD 129 as investment banks for the issuer,221 provide security analysis and brokerage services in the same stock and possess location or industry-specific expertise,222 or appoint representatives to their client firms.223 “[M]arket making [on the NASDAQ] is typically bundled with brokerage, analyst coverage and underwriting in the same firm.”224

An extreme possibility is that insiders themselves could engage in market making. For instance, Henry G. Manne noted

the desirability of allowing insiders in corporations to do something on the order of “making a market” in their company’s shares. . . . [T]hey are in the best position to do that job effectively, and, in spite of some expressed fears that they would spend all their time trading in the market, there is really no reason to believe that this practice would have undesirable effects on their managerial skills.225

Furthermore, insiders “will not suffer the adverse selection problem and will have no reason to add a risk premium to the service of making a

absence of insider trading. “The more predictable the stock price movements to the specialists, the easier for a specialist to minimize pricing risk and to decrease his spread.” Oesterle et al., supra note 107, at 296 n.339. See also Manne, supra note 37, at 574 (stating that “[i]n over-the-counter stocks, where market makers may still occupy positions on boards of directors . . . it is difficult to see the market maker as anything other than a privileged insider”). 221 See Katrina Ellis et al., When the Underwriter is the Market Maker: An Examination of Trading in the IPO Aftermarket, 55 J. FIN. 1039 (2000). Another empirical study documented lower bid-ask spreads for IPO issues underwritten by market makers. Shantaram P. Hegde & Robert E. Miller, Market-Making in Initial Public Offerings of Common Stocks: An Empirical Analysis, 24 J. FIN. & QUANTITATIVE ANALYSIS 75, 87 (1989). “[T]he underwriter-dealers hold an information advantage with respect to new issues because of the privileged information they collected as a by-product of the underwriting process. Consequently, the underwriter-dealers tend to feel less threatened by adverse information risk in the immediate aftermarket.” Id. 222 Paul Schultz, Who Makes Markets, 6 J. FIN. MARKETS 49, 50 (2003). 223 One study examined the instances when securities firms appoint their representatives (typically, to the board of directors) to the corporations in which they make markets. H. Nejat Seyhun, Conflicts of Interest in Securities Firms and Chinese Walls? (Oct. 30, 2002) (unpublished manuscript, on file with author). This arrangement typically resulted in lower bid-ask spreads as well as much smaller profits to the corporate insiders from legal insider trading, suggesting a flow of private information to the market maker. 224 Schultz, supra note 222, at 72. 225 Manne, supra note 37, at 574.

130 CAPITAL UNIVERSITY LAW REVIEW [33:83 market.”226 Yet, in an unregulated regime, direct competition of insiders and full-time professionals in providing liquidity is unlikely, despite the advantages of the former category pertaining to inside information, because of the economies of scale and scope in securities research enjoyed by full-time market makers, the cost of access to trading facilities, and the capital needed to carry sufficient inventory.227 Direct participation of insiders in market making or their exclusive communication with liquidity providers would be primarily reflected in the market price and not the spread’s size. The security’s anticipated value is likely to be outside the original bid-ask spread anyway, and market makers compete on the basis of individual bid and ask quotes, not on the basis of the narrowest spread. C. Summary

Informed trading is detected by liquidity providers, and this decreases their trading losses, depending on the relevant market’s characteristics. Nevertheless, the adverse selection model retains its validity: it is still possible that, while the market is trying to learn the ultimate impact of the information possessed by informed traders, a market maker would still be forced to increase the bid-ask spread. If insiders have access to a constant stream of information not available to liquidity providers, this, theoretically, may imply a persisting higher spread if the inventory management practices are ignored.

VII. SPREAD, DISCLOSURE, INSIDER TRADING, VOLATILITY, AND FIRM SIZE

A. Proposed Theoretical Link One of the principal theoretical works on adverse selection linked the

bid-ask spread and firm size to provide the explanation for the “small firm effect.”228 Existence of larger spreads and higher returns for the stocks of smaller companies is often attributed to greater informational asymmetries and better opportunities for insider trading in such firms.229 This is plausible, but there is a more complex web of interrelations among bid-ask spreads, insider trading, quality of disclosure, stock price volatility, and firm size. The significance of small companies is that they tend to have less corporate transparency, more substantial insider trading activity, lower disclosure standards, greater stock price volatility, lower trading volume, and less analysts’ coverage.

_______________________________________________________ 226 Manne, supra note 95, at 18. 227 A more feasible scenario is market making by the issuer itself instead of corporate insiders in their individual capacities. Id. at 25 n.40. 228 Glosten & Milgrom, supra note 68, at 75. 229 See id.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 131 It is true that there is a correlation between firm size and the intensity

of insider trading.230 In smaller firms, informed trading can be more advantageous, as “significant” inside information is typically known to fewer individuals and probably remains unrecognized by the market for a longer period of time.231 The assets of smaller firms are often concentrated in intellectual property, such as research and development (R&D) and other intangibles, and growth opportunities whose value is not readily visible to outsiders. Consequently, insiders in small companies possess more substantial advantages to profit on market mispricings.232 Similarly, in small firms, a relatively minor event can have a large impact on the stock price.233 Generally, engaging in legal trading, “insiders in small firms earn substantially greater abnormal returns than the insiders in large firms.”234 H. Nejat Seyhun also cites evidence that the probability of insider trading for a “very large” company is around 0.005, while for a “very small” one, it is between 0.020 and 0.025.235

B. Alternative Explanations Scholars have provided the following possible explanations for larger

spreads in less frequently traded stocks (which tend to correspond to small market capitalization firms):

If a stock trades infrequently, the specialist handling the stock may have to maintain an inventory imbalance for a long period. This lack of liquidity may induce a risk averse specialist to set higher spreads to compensate for the exposure . . . . For many inactive stocks, only a single market maker provides liquidity, with few limit order traders willing to post competing orders. This monopoly

_______________________________________________________ 230 See Manne, supra note 95, at 23 n.38. 231 See Fried, supra note 107, at 327. 232 See generally David Aboody & Baruch Lev, Information Asymmetry, R&D, and Insider Gains, 55 J. FIN. 2747 (2000) (finding a positive relationship between R&D expenses and the profitability of legal insider trading); Russell W. Coff & Peggy M. Lee, Insider Trading as a Vehicle to Appropriate Rent from R&D, 24 STRATEGIC MGMT. J. 183 (2003) (finding that the price impact of legal insider purchases is larger for R&D-intensive firms). 233 See MANNE, supra note 5, at 143. 234 H. Nejat Seyhun, Insiders’ Profits, Costs of Trading, and Market Efficiency, 16 J. FIN. ECON. 189, 201 (1986). See also Fried, supra note 107, at 327. 235 H. NEJAT SEYHUN, INVESTMENT INTELLIGENCE FROM INSIDER TRADING 9 (1998).

132 CAPITAL UNIVERSITY LAW REVIEW [33:83 position may allow the market maker to set larger spreads than would arise in a competitive environment.236

In the same fashion, there are alternative explanations for the relationship between firm size and equity returns. While the hypothesis that insider trading increases the cost of capital through higher spreads is logical, higher returns for small firms may be due to lower transaction demand.237 Small firms may have ownership transfer restrictions and are less likely to be included in equity indexes or thoroughly followed by securities analysts.238

From the perspective of corporate governance, higher returns for smaller companies may be attributed to “private benefits of control” since they are more likely to have a majority owner:

The difficulty is that concentrated ownership . . . may simply lead to a situation where decisions are made to the benefit of the large shareholder and of management . . . . As smaller shareholders become disenfranchised, the cost of capital for the corporation increases because shareholders who buy shares expect to receive a smaller fraction of the firm’s cash flows.239

Some also suggest that higher returns for small firms are due to the tendency of small firms to have “high financial leverage and cash flow problems [and, being more sensitive to economy- and industry-wide changes] react differently from the healthy firms to the same piece of _______________________________________________________ 236 David Easley et al., Liquidity, Information, and Infrequently Traded Stocks, 51 J. FIN. 1405, 1406 (1996) (footnote omitted). Ultimately, this study, examining ninety NYSE stocks, found that “large spreads in [low-volume] stocks are not merely the result of market power by market makers, or difficulties in risk-bearing due to inventory. Less active stocks are riskier because they are subject to more information-based trading.” Id. at 1428. The correlation between the probability of informed trading and the size of the bid-ask spread led to this conclusion, and the study largely ignored the cost of carrying inventory. Id. at 1426. 237 Corporations with small capitalization usually are not actively traded. 238 This is probably due to the fixed cost component in securities research, which makes it more advantageous to follow larger firms. See Bonnie F. Van Ness et al., How Well Do Adverse Selection Components Measure Adverse Selection?, FIN. MGMT., Autumn 2001, at 77, 86. 239 René M. Stulz, Does Financial Structure Matter for Economic Growth? A Corporate Finance Perspective 21-22 (Jan. 24, 2000) (unpublished manuscript, on file with author). See also Alexander Dyck & Luigi Zingales, Private Benefits of Control: An International Comparison, 59 J. FIN. 537 (2004); Tatiana Nenova, The Value of Corporate Voting Rights and Control: A Cross-Country Analysis, 68 J. FIN. ECON. 325 (2003).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 133 macroeconomic news.”240 Hence, the “small firm effect” may reflect additional market risk.241

It is generally true that companies with lower disclosure standards (that also tend to have smaller capitalization) have higher bid-ask spreads,242 and, intuitively, more extensive disclosure implies fewer opportunities for insider trading.243 Consequently, some works argue that increased disclosure deters some amount of insider trading, which, in turn, decreases spreads. For instance, Michael Welker discusses “the adverse selection problem confronting specialists when material, firm-specific information may exist but has not been publicly disclosed by the firm. This ‘withheld’ information may be privately available to select traders, creating an ongoing adverse selection problem.”244

However, there is another plausible relationship between disclosure and spreads. “Disclosure improves future liquidity of a firm’s securities (reduces price impact).”245 Thus, even in the absence of insider trading, firms with lower standards of disclosure will have greater stock price volatility that increases the market maker’s costs of carrying inventory and, consequently, the bid-ask spread.246

_______________________________________________________ 240 K.C. Chan & Nai-Fu Chen, Structural and Return Characteristics of Small and Large Firms, 46 J. FIN. 1467, 1468 (1991). This could also explain higher stock price volatility for smaller companies. 241 See Jonathan B. Berk, A Critique of Size-Related Anomalies, 8 REV. FIN. STUD. 275, 277 (1995). 242 For empirical evidence on the link between the disclosure quality and bid-ask spreads, see Jeffery P. Boone, Oil and Gas Reserve Value Disclosures and Bid-Ask Spreads, 17 J. ACCT. & PUB. POL’Y 55 (1998); Marilyn Magee Greenstein & Heibatollah Sami, The Impact of the SEC’s Segment Disclosure Requirement on Bid-Ask Spreads, 69 ACCT. REV. 179, 180-82 (1994); Paul M. Healey et al., Stock Performance and Intermediation Changes Surrounding Sustained Increases in Disclosure, 16 CONTEMP. ACCT. RES. 485, 506 (1999); Christian Leuz & Robert E. Verrecchia, The Economic Consequences of Increased Disclosure, 38 J. ACCT. RES. S91, S114-16 (2000); Chee Yeow Lim et al., Information Asymmetry and Accounting Disclosures for Joint Ventures, 38 INT’L

J. ACCT. 23 (2003); Michael Welker, Disclosure Policy, Informational Asymmetry, and Liquidity in Equity Markets, 11 CONTEMP. ACCT. RES. 801, 804 (1995). 243 For instance, one empirical study found a negative relationship between the quality of disclosure and the estimate for the probability of informed trading. Stephen Brown et al., Disclosure Quality and the Probability of Informed Trade 33 (Dec. 2001) (unpublished manuscript, on file with author). 244 Welker, supra note 242, at 803. 245 Douglas W. Diamond & Robert E. Verrecchia, Disclosure, Liquidity, and the Cost of Capital, 46 J. FIN. 1325, 1326 (1991). 246 See infra note 314 and accompanying text.

134 CAPITAL UNIVERSITY LAW REVIEW [33:83

C. Summary Thus, the theoretical approach of the adverse selection literature may

confuse causation and correlation. By itself, the “small firm effect” does not conclusively prove that insider trading causes higher bid-ask spreads. Theoretically, higher spreads for smaller firms may coexist with the absence of informed trading.

VIII. CREAM-SKIMMING AND PAYMENT FOR ORDER FLOW A. Proposed Explanations for Market Makers’ Practices

An implication of the adverse selection model is that market makers should refrain from dealing with informed traders or engage in price discrimination. Consequently, such practices of liquidity providers as “cream-skimming” and payment for order flow were used to support the model’s validity.

The “cream-skimming” hypothesis suggests that some market makers, such as dealers or specialists on “satellite” exchanges and “third market” dealers, actively seek to obtain uninformed orders by attracting small retail trades and thus leave informed trades to be executed on the dominant exchange.247 “[T]he burden of adverse selection falls disproportionately on the primary exchange specialist, who loses the ‘safe’ business of the retail customer but must accept the problematic trades of the professional.”248 This view has also been adopted by the SEC:

Informed orders . . . represent a substantial risk to liquidity providers that take the other side of these informed trades. In contrast, orders submitted by persons without an information advantage (often small orders) present less risk to liquidity providers and in theory should receive the most favorable effective spreads available in the market. Market centers may attempt to identify and secure a substantial flow of uninformed orders, while avoiding, and perhaps even rejecting, informed orders. The average realized spread statistic for market and marketable limit orders can highlight the extent to which market centers

_______________________________________________________ 247 See David Easley et al., Cream-Skimming or Profit Sharing? The Curious Role of Purchased Order Flow, 51 J. FIN. 811, 812 (1996). 248 John C. Coffee, Jr., Comment, in THE INDUSTRIAL ORGANIZATION AND

REGULATION OF THE SECURITIES INDUSTRY 78, 82 (Andrew W. Lo ed., 1996).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 135 receive uninformed orders (as indicated by higher realized spreads than other market centers).249

Empirically, it is certainly true that regional exchanges specialize in smaller orders: “[S]mall orders of all types account for 49% . . . of all NYSE orders, but this ratio ranges from 76% to 86% for the regional exchanges.”250 There is also empirical evidence that the probability of informed trading is, in fact, lower on regional exchanges,251 and that price discovery predominantly occurs on the central exchange, suggesting that most informed trades take place there.252

Some further argue that the adverse selection rationale may lie behind the phenomenon of payment for order flow—the fact that dealers often pay retail brokers for diverted orders.253 “If the market maker could be assured of obtaining primarily the order flow of uninformed traders, that market maker would face smaller losses to informed traders than implicit in the displayed spread, making it again profitable to pay for order flow.”254

_______________________________________________________

(continued)

249 Disclosure of Order Execution and Routing Practices, Exchange Act Release No. 43,590, 65 Fed. Reg. 75,414 (Nov. 17, 2000). The industry met this point of view with some skepticism: “Apparently, the Commission believes that if uninformed orders are executed at prices established by markets with a substantial volume of informed order flow, they may generate increased trading profits for liquidity providers and that the average realized spread will highlight the extent to which the market centers receive uninformed orders.” Letter from Jeffrey T. Brown, Vice President Regulation and General Counsel, Cincinnati Stock Exchange, to Jonathan G. Katz, Secretary, Securities and Exchange Commission 4 (Sept. 25, 2000), available at http://www.sec.gov/rules/proposed-/s71600/brown1.htm (last visited Jan. 11, 2005). See also OFFICE OF ECON. ANALYSIS &

OFFICE OF COMPLIANCE INSPECTIONS, SEC, SPECIAL STUDY: PAYMENT FOR ORDER FLOW

AND INTERNALIZATION IN THE OPTIONS MARKET (2000) (“Retail customer options orders are considered the most profitable because these orders are often ‘uninformed.’”), available at http://www.sec.gov/news/studies/ordpay.htm (last visited Jan. 11, 2005). 250 Mark A. Peterson & Erik R. Sirri, Order Preferencing and Market Quality on U.S. Equity Exchanges, 16 REV. FIN. STUD. 385, 395 (2003). 251 See Easley et al., supra note 247, at 831. 252 See Joel Hasbrouck, One Security, Many Markets: Determining the Contributions to Price Discovery, 50 J. FIN. 1175, 1197 (1995). 253 See Marshall E. Blume & Michael A. Goldstein, Quotes, Order Flow, and Price Discovery, 52 J. FIN. 221, 225-27 (1997). 254 Id. at 226. See also Lawrence Harris, Consolidation, Fragmentation, Segmentation and Regulation, 2 FIN. MARKETS, INST. & INSTRUMENTS 1, 18 (1993) (“The order-purchasing dealers presumably will only trade with relatively uninformed traders. Other dealers, such as exchange specialists, may not have the legal discretion (or perhaps the competence) to discriminate among orders.”). However, an authoritative industry report on the inducements for order flow by a committee chaired by David S. Ruder, a former SEC

136 CAPITAL UNIVERSITY LAW REVIEW [33:83 Payment for order flow is closely related to “cream-skimming,” and these two practices are often combined.255

B. Critique of the Adverse Selection Approach to “Cream-Skimming” If the adverse selection rationale for “cream-skimming” is true, the

implication is that the diversion of uninformed order flow off the central exchange should increase its average bid-ask spread. Yet, Mark A. Peterson and Erik R. Sirri found the following:

The NYSE dominates the regional exchanges for most measures of market quality . . . . This pattern is somewhat surprising in light of predictions of adverse selection models [maintaining that] orders with low information content, such as those of individual investors, should execute at more favorable prices than those of informed trades.256

The adverse selection motivation for “cream-skimming” is also inconsistent with evidence that “third market” trading is concentrated in the most actively-traded NYSE and AMEX securities, which allows dealers “to offset any position, whether acquired from informed or uninformed traders, by quickly trading against the constant incoming stream of buy and sell orders.”257 This makes the market makers’ concern for trading with informed transactors less relevant.258 An empirical study by Robert H. Battalio raises similar doubts.259 It found that the entrance of a major “third market” broker-dealer led to a decrease in the bid-ask spread on the dominant market.260 “[T]he potential adverse selection problem associated with allowing agents to selectively execute orders may

Chairman and then-member of the National Association of Securities Dealers Board of Governors, did not mention the adverse selection argument. See PAYMENT FOR ORDER

FLOW COMM., INDUCEMENTS FOR ORDER FLOW: A REPORT TO THE NASD BOARD OF GOVERNORS (1991), available at http://www.academic.nasdaq.com/docs/wp91_1.pdf (last visited Jan. 11, 2005). Recently, commentators and industry representatives have extensively criticized the practice of payment order flow because it allegedly creates persistent conflicts of interest. See, e.g., Ferrell, supra note 107. 255 See Beny, supra note 107, at 431. 256 Peterson & Sirri, supra note 250, at 387, 400. 257 Ferrell, supra note 107, at 1079-80. 258 See id. 259 Robert H. Battalio, Third Market Broker Dealers: Cost Competitors or Cream Skimmers?, 52 J. FIN. 341, 350-51 (1997). 260 Id.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 137 be economically insignificant.”261 A similar study suggested “an economically insignificant adverse selection problem associated with fragmenting the market by making it easier for retail brokerage houses to execute orders selectively in NYSE-listed securities.”262

C. Critique of the Adverse Selection Approach to Payment for Order Flow Similarly, there are reasons to doubt that the adverse selection rationale

applies to payments for diverted orders. As Allan Ferrell argued, “it is difficult to determine whether small orders are being diverted to dealers due to cream skimming or because they are placed by small [uninformed] investors who do not monitor execution quality.”263 Empirical evidence does indicate that

[t]he NYSE executes only 0.08 percent of its total dollar volume . . . when neither its bid or ask price matched the best prices, [while] non-NYSE markets executes [sic] on average anywhere from 34.7 percent for Cincinnati to 92.1 percent for Philadelphia of their dollar trading volume when not part of the best prices.264

This evidence questions the value of order flow diversion, unless it provides something other than the execution quality. It also indicates that the costs of handling “purchased” orders are unlikely to be lower and thus unlikely to avoid an extra component. Additionally, alternative explanations for the practice of payment for order flow posit that its existence could be due to large tick sizes common on the dominant

_______________________________________________________ 261 Id. at 351. 262 Robert Battalio et al., Do Competing Specialists and Preferencing Dealers Affect Market Quality?, 10 REV. FIN. STUD. 969, 988-89 (1997). 263 Ferrell, supra note 107, at 1079. For a similar comment, see NYSE, INC., MARKET STRUCTURE REPORT, supra note 169, at 26 n.56 (“It seems likely that this [diversion of the] smaller-sized order flow in NYSE-listed stock[s] is primarily because the investors involved in placing these types of orders are generally not well informed about order-execution practices, and consequently do not actively monitor their broker-dealers or otherwise seek to direct their order flow to a particular market.”). See also Harris, supra note 254, at 17 (noting that small public traders typically cannot monitor the execution quality but can observe and compare the commission fee). 264 Blume & Goldstein, supra note 253, at 234. But this may also imply non-price competition. Id. See also Robert Battalio et al., All Else Equal?: A Multidimensional Analysis of Retail, Market Order Execution Quality, 6 J. FIN. MARKETS 143, 143 (2003) (finding that “retail market orders obtain better trade prices on the NYSE but faster executions, more depth improvement, and order-flow payment at Trimark Securities, a Nasdaq dealer”).

138 CAPITAL UNIVERSITY LAW REVIEW [33:83 exchanges in the recent past or to its pro-competitive nature as a price rebate.265

D. Summary There are reasons to doubt the assertion that dealers off the dominant

exchanges capture small orders because they are likely to be uninformed. It is possible that such dealers have a comparative advantage in attracting retail trades or that they are not well-equipped to handle larger trades due to inadequate capital or the price impact of such transactions. It is also doubtful that all small transactions are necessarily less informed, as insiders are likely to split their orders because it is easier for the regulators and exchanges to monitor and trace larger transactions.266 However, some large orders could be based on fundamental or non-fundamental “outside” information or sophisticated research. Additionally, there is anecdotal evidence that some “third market” dealers prefer smaller orders due to information concerns.267

IX. INFORMED TRADING AND MARKET MAKING IN DERIVATIVE MARKETS

A. Stock or Option Markets for Informed Trading? It is often suggested that informed traders prefer to use options

markets, as they provide more financial leverage, lower implicit interest rates, and more opportunities to circumvent short-selling restrictions.268 Indeed, there is evidence that, in some instances, the derivatives markets are the preferred venue for informed trading.269 Consequently, it is _______________________________________________________

(continued)

265 See Beny, supra note 107, at 428-29. Another study found evidence that payments for order flow translate into lower commissions. See Robert Battalio et al., The Relationship Among Market-Making Revenue, Payment for Order Flow, and Trading Costs for Market Orders, 19 J. FIN. SERV. RES. 39, 54 (2001). 266 There is empirical evidence that medium and large trades are more “informative” to the market in terms of their price impact. See Michael J. Barclay & Jerold B. Warner, Stealth Trading and Volatility: Which Trades Move Prices?, 34 J. FIN. ECON. 281, 304 (1993); Sugato Chakravarty, Stealth-Trading: Which Traders’ Trades Move Stock Prices?, 61 J. FIN. ECON. 289, 297 (2001). However, just because small trades do not have the same price impact does not necessarily mean that they are less informed. Individual smaller transactions could be more difficult to identify as informed, and they exert less temporary price pressure. 267 Vinzant, supra note 116, at 258. 268 See, e.g., Raman Kumar et al., The Impact of Options Trading on the Market Quality of the Underlying Security: An Empirical Analysis, 53 J. FIN. 717, 718-19 (1998). 269 See David Easley et al., Option Volume and Stock Prices: Evidence on Where Informed Traders Trade, 53 J. FIN. 431, 432 (1998); Jason Lee & Cheong H. Yi, Trade Size

2004] INSIDER TRADING AND THE BID-ASK SPREAD 139 desirable to investigate whether the adverse selection problem is relevant for options market makers and its consequences for the markets in underlying securities. B. Relevance of Adverse Selection for Options Market Makers

Insider trading may be a problem for options market makers—options writers and frequent traders—due to difficulties in managing their inventory and hedging their positions.270

[Options] market makers must use their own capital to complete anywhere from 40% to 100% of trades in the options in which they make markets. That’s because buyers and sellers of options can pick and choose between dozens of options positions on the same stock with a

and Information-Motivated Trading in the Options and Stock Markets, 36 J. FIN. &

QUANTITATIVE ANALYSIS 485, 499 (2001); Tom Arnold et al., Speculation or Insider Trading: Informed Trading in Options Markets Preceding Tender Offer Announcements 23 (May 2000) (unpublished manuscript, on file with author). For a discussion of legal issues concerning insider trading in options, see Harvey L. Pitt & Karl A. Groskaufmanis, A Tale of Two Instruments: Insider Trading in Non-Equity Securities, 49 BUS. LAW. 187 (1993). 270 See also Prime Mkts. Group v. Masters Capital Mgmt., No. 01 C 6840, 2003 U.S. Dist. LEXIS 7928 (N.D. Ill. May 7, 2003) (examining allegations by CBOE options market makers claiming harm from insider trading in connection with an upcoming merger announcement); In re Motel 6 Sec. Litig., 161 F. Supp. 2d 227 (S.D.N.Y. 2001) (same); Abrams v. Prudential Sec., No. 99 C 3884, 2000 U.S. Dist. LEXIS 18541 (N.D. Ill. Mar. 20, 2000) (same); Goldsmith v. Pinez, 84 F. Supp. 2d 228 (D. Mass. 2000) (same); TFM Inv. Group v. Bauer, No. 99-840, 1999 U.S. Dist. LEXIS (E.D. Pa. Sept. 24, 1999) (examining allegations by a Philadelphia Stock Exchange options market maker claiming harm from insider trading in connection with an upcoming merger announcement); Rosenbaum & Co. v. H.J. Myers & Co., No. 97-824, 1997 U.S. Dist. LEXIS 15720 (E.D. Pa. Oct. 9, 1997) (examining allegations by Philadelphia Stock Exchange options market makers claiming harm from insider trading in connection with an upcoming acquisition announcement); SEC v. Certain Unknown Purchasers, No. 81 Civ. 6553, 1983 U.S. Dist. LEXIS 15226 (S.D.N.Y. July 25, 1983) (examining allegations made by a Pacific Stock Exchange options market maker claiming harm from insider trading in connection with an upcoming acquisition announcement). The SEC also stressed that insider trading harms options market makers. See Insider Trading: Hearings Before the Subcomm. on Telecomm., Consumer Prot., and Fin. of the House Comm. on Energy and Commerce, 99th Cong. 38 (1987) (statement of John Shad, Chairman, Securities and Exchange Commission) (stating that “[w]e have got cases where the insider traders have bought call options for a negligible price, just shortly before a public announcement of a tender offer for the company, that has caused the marketmakers in those options to go bankrupt, to lose millions of dollars”).

140 CAPITAL UNIVERSITY LAW REVIEW [33:83 variety of strike prices and expiration dates, making it practically impossible to match each transaction . . . .271

The court in SEC v. Wang utilized a similar approach:272

The distinction between stock and options traders is justified because of differences in the nature of the losses borne by such traders as a result of [insider trading]. For example, options traders that wrote uncovered call options, that is, options on stock not in inventory, assumed great risk of loss if the underlying stock price rose, particularly those obligated to do so by virtue of requirements applicable to market makers. . . . [T]here simply were no comparable losses (or risks of loss) suffered by market makers in stocks.273

Thus, many transactions made on private information may be marginal for an options writer and expose him to losses—not just a drop in the market value of his portfolio, but also a cash outflow. This increased cost of writing options certainly has an effect on their price and liquidity, which in turn may be harmful to the equity markets.

On the other hand, it is possible that a derivatives liquidity provider could hedge the informed trading risk. One study posits and presents supporting empirical evidence that “[i]n a perfect hedge world, spreads [quoted by an options market maker] arise from the illiquidity of the underlying market, rather than from inventory risk or informed trading in the option market itself.”274 Options market makers could also hedge the risk of adverse price movements by holding related options in their portfolios.275 Furthermore, there is evidence that futures market makers efficiently manage their inventory276 and hence neutralize the risk of loss from informed trading.

_______________________________________________________ 271 McGee, supra note 118. 272 944 F.2d 80, 86-87 (2d Cir. 1991). 273 Id. at 86. 274 YOUNG-HYE CHO & ROBERT F. ENGLE, MODELING THE IMPACTS OF MARKET

ACTIVITY ON BID-ASK SPREADS ON THE OPTION MARKET 29 (Nat’l Bureau of Econ. Research, Working Paper No. 7331, 1999). An earlier discussion of hedging the risk of insider trading by options writers is found in MANNE, supra note 5, at 46, 251 n.9. 275 See William L. Silber, Marketmaking in Options: Principles and Implications, in FINANCIAL OPTIONS: FROM THEORY TO PRACTICE 485, 490 (Stephen Figlewski et al. eds., 1990). 276 See supra note 158.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 141

C. Option Listings and the Liquidity of the Underlying Stock Empirical research documented that the introduction of options is

associated with improvements in liquidity for the underlying securities. Some suggest that this increase in liquidity may be due to the migration of informed traders to the options markets, which, in turn, reduces the adverse selection concern for market makers in the underlying stock.277 For instance, one empirical study found that “option listings are associated with a decrease in the adverse selection component of the underlying stock’s bid-ask spread.”278

At the same time, it is possible that derivatives improve liquidity of equity markets for different reasons: “[O]ption trading enhances market efficiency by helping stock prices adjust to the release of information relevant to firm valuation. Further[more], options lead to wider dissemination of useful information, because investors can infer relevant, current information relating to stock volatility from option contract premiums.”279 The existence of options markets makes the equity market more efficient, as options trading circumvents the restrictions on or infeasibility of short selling and thus improves the aggregation of information.280 In other words, options markets improve the efficiency, _______________________________________________________

(continued)

277 Kumar et al., supra note 268, at 718-19. This interpretation has its genesis in a famous article by Fischer Black: “It would not be surprising to find that the market makers’ and specialists spreads are higher on the options market than the spreads for equivalent positions in the stock market, because ‘information trading’ may tend to shift from the market for a stock to the market for its options.” Fischer Black, Fact and Fantasy in the Use of Options, FIN. ANALYSTS J., July–Aug. 1975, at 36, 61. However, from the theoretical perspective, spreads for options are generally greater than spreads for stocks because of the synthetic replication costs. See ROBERT C. MERTON, CONTINUOUS-TIME

FINANCE 432-40 (rev. ed. 1992). “The analysis shows that the percentage spreads in the production costs of derivative securities can be many times larger than the spreads in their underlying securities.” Id. at 440. 278 Kumar et al., supra note 268, at 731. A similar empirical study also argued that the introduction of options reduces the adverse selection component of equity bid-ask spreads, but has no significant effect on their absolute size. See Suhkyong Kim & J. David Diltz, The Effect of Option Trading on the Structure of Equity Bid/Ask Spreads, 12 REV. QUANTITATIVE ACCT. & FIN. 395, 405 (1999). 279 Note, Private Causes of Action for Option Investors Under SEC Rule 10b-5: A Policy, Doctrinal, and Economic Analysis, 100 HARV. L. REV. 1959, 1965 (1987) (footnote omitted). 280 See Stephen Figlewski & Gwendolyn P. Webb, Options, Short Sales, and Market Completeness, 48 J. FIN. 761, 768 (1993) (presenting evidence that “unfavorable information is underweighted in prices when the market constraints short sales, but that option trading helps to reduce the inefficiency”); Sugato Chakravarty et al., Informed

142 CAPITAL UNIVERSITY LAW REVIEW [33:83 and hence liquidity, of underlying stocks precisely because informed trading in derivatives enhances the process of price discovery.281

D. Estimate of Adverse Selection in Derivatives Markets Some empirical studies attempted to estimate the magnitude of the

adverse selection problem for derivatives markets. Anand Vijh found the adverse selection component of the CBOE options’ bid-ask spreads to be 2%.282 In contrast, Jason Lee and Cheong H. Yi estimated this component of the CBOE spreads at 38%283 and criticized the results obtained by Vijh on the grounds that his study focused on larger options trades that are less likely to be informed.284 Jianxin Wang analyzed bid-ask spreads on the Sydney Futures Exchange and found the adverse selection component to be between 17% and 56%, depending on the type of futures contract and whether the type of trading system in question is floor-based or automated.285

E. Derivatives Industry’s Views A recent initiative of the SEC solicited comments on the validity of a

variant of the adverse selection argument for options markets.286 The SEC posed the following questions for public comment:

Trading in Stock and Option Markets, 59 J. FIN. 1235, 1235 (2004) (estimating the magnitude of the options’ contribution to price discovery for the underlying stocks). 281 In fact, several empirical studies pointed out that the introduction of options tends to make stock prices less volatile. See Jennifer Conrad, The Price Effect of Option Introduction, 44 J. FIN. 487, 487 (1989); Aswath Damodaran & Joseph Lim, The Effects of Option Listing on the Underlying Stocks’ Return Processes, 15 J. BANKING & FIN. 647, 647 (1991); Douglas J. Skinner, Option Markets and Stock Return Volatility, 23 J. FIN. ECON. 61, 61 (1989). Decreased volatility as such also reduces market makers’ inventory costs and thus reduces the spread. See infra note 314 and accompanying text. See also Ramesh P. Rao et al., Dealer Bid-Ask Spreads and Options Trading on Over-the-Counter Stocks, 14 J. FIN. RES. 317, 324 (1991) (arguing that “option listings have a favorable impact on spreads by affecting both the inventory-holding costs and informed-trading risk components of spreads”). 282 Anand M. Vijh, Liquidity of the CBOE Equity Options, 45 J. FIN. 1157, 1177 (1990). 283 Lee & Yi, supra note 269, at 496. 284 Id. at 487. 285 Jianxin Wang, Asymmetric Information and the Bid-Ask Spread: An Empirical Comparison Between Automated Order Execution and Open Outcry Auction, 9 J. INT’L FIN. MARKETS, INST. & MONEY 115, 125 (1999). 286 See Competitive Developments in the Options Markets, Exchange Act Release No. 41,975, 69 Fed. Reg. 6,124-01 (Feb. 9, 2004).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 143 Do market makers establish the price and size of their public quote based on the assumption that they may trade with an informed professional, which involves more risk than trading with an uninformed non-professional? . . . If commenters agree that public quotes are based on the assumption that the market maker may trade with a professional, are such quotes wider than they would be if market makers only received uninformed, non-professional orders?287

Most commentators from the securities industry questioned the idea that options market makers lose by trading with better informed counterparties, although the emphasis was on market professionals rather than inside traders.288 However, the comment that discussed insider _______________________________________________________

(continued)

287 Id. 288 Letter from Michael Whitman, Secretary/Treasurer, Options Market Maker Association of the American Stock Exchange, to Jonathan G. Katz, Secretary, Securities and Exchange Commission (Apr. 8, 2004) (stating that “it is irrelevant who the other side of a trade is”), available at http://www.sec.gov/rules/concept/s70704/mwhitman9287.htm (last visited Sept. 14, 2004); Letter from Adam C. Cooper, Senior Managing Director and General Counsel, Citadel Investment Group, LLC, to Jonathan G. Katz, Secretary, Securities and Exchange Commission 3 (Apr. 13, 2004) (criticizing “the fallacy of the most common argument against requiring firm quotes in options markets for all market participants: that ‘professional traders’ will put market makers out of business if market makers are required to execute professional orders at quoted prices”), available at http://www.sec.gov/rules/concept/s70704/-citadel04132004.pdf (last visited Jan. 11, 2005); Letter from William J. Brodsky, Chairman and Chief Executive Officer, CBOE, to Jonathan G. Katz, Secretary, Securities and Exchange Commission, at ex. A, 5 (Apr. 16, 2004) (noting that “market makers generally are equally willing to trade with professional and nonprofessional orders is evidenced today by the fact that most exchanges allow all order types to receive automatic executions regardless of whether they are professional or nonprofessional, informed or noninformed.”), available at http://www.sec.-gov/rules/concept/s70704/cboe04162004.pdf (last visited Jan. 11, 2005). See also Letter from Salvatore F. Sodano, Chairman and Chief Executive Officer, AMEX, LLC, to Jonathan G. Katz, Secretary, Securities and Exchange Commission 7 (Apr. 8, 2004) (“Academic literature suggests that market makers will inevitably widen and reduce the size of their markets if they believe that their counterparties have an informational advantage. [But] whether a market maker assumes that it may be trading with an informed professional depends on the particular market maker and its trading philosophy.”), available at http://www.sec.gov/rules/concept-/s70704/s70704-5.pdf (last visited Jan. 11, 2005); Letter from William J. Brodsky to Jonathan G. Katz, supra, at ex. A, 5 n.12 (“Conceptually, CBOE disagrees with the SEC’s characterization of nonprofessional orders as ‘uninformed’ while at the same time characterizing professional orders as ‘informed.’ It is our experience

144 CAPITAL UNIVERSITY LAW REVIEW [33:83 trading specifically stated the following: “Taking advantage of unforeseen, news-related stock moves, dividend changes or some other form of insider information, these orders almost always represent the most pre-hedge risk from the perspective of a [market maker]. Insider orders are the primary reason why the public quote does not always represent the best market.”289

F. Summary Thus, the case of derivatives markets does offer some support for the

adverse selection model: there is evidence that options market makers are, in some instances, harmed by insider trading. On the other hand, this evidence is not unambiguous, as derivatives market makers still have opportunities to protect themselves from informed trading and the empirical relationship between the options and equity markets may support different interpretations.

X. OVERALL MARKET LIQUIDITY AND INSIDER TRADING REGULATION

A. Alternative Links Between Regulation and Market Liquidity Correlation between the overall stock market liquidity and insider

trading regulation is sometimes interpreted in favor of the adverse selection model, as in the case of the “market integrity”/“investor confidence” argument. According to one commentator, insider trading leads “to increased bid-ask spreads and a potentially less liquid securities market . . . . Some studies indicate that markets characterized by weaker insider trading regimes are less liquid than those markets in which prohibitions against insider trading are stringently enforced.”290 In fact, one empirical study connected the tightening of insider trading regulation in the United States in the 1980’s to the subsequent lower spreads.291 One frequently

that nonprofessional (i.e., customer) orders may be very informed while, conversely, some professionals may be very uninformed.”). 289 Letter from Mark Liu, Head Options Specialist, AGS Specialist Partners, to Jonathan G. Katz, Secretary, Securities and Exchange Commission (Apr. 15, 2004), available at http://www.sec.gov/rules/concept/s70704/mliu8271.htm (last visited Jan. 11, 2005). 290 Krawiec, supra note 107, at 469-70. 291 Vaughn S. Armstrong, The Microstructure of Informed Trading: A Theoretical and Empirical Analysis of Insider Trading Sanctions 107-08 (1995) (unpublished Ph.D. dissertation, Arizona State University, 1995) (on file with author). Yet, the study also found that the regulatory tightening was associated with an increase in the profitability of informed trading and a decline in the market depth. Id. at 107, 159.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 145 cited study also links the cost of equity and the enforcement of insider trading regulations, referring to the adverse selection argument.292

Yet, the causal link between regulation and market liquidity may run in the opposite direction. “[L]arger and more liquid stock markets are more likely to enact and enforce insider trading laws,”293 as such markets provide greater opportunities for insider trading because of greater anonymity and lower transaction costs. They also possess well-organized groups of market professionals that are likely to push for regulating trading by corporate insiders to further their own interests.294 Thus, regulatory developments may have followed market liquidity instead of causing it. In some instances, liquid securities markets coexisted with the lack of insider trading regulation,295 and recent adoption of such regulation in many countries could be due to pressure exerted by the SEC to increase the effectiveness of the domestic enforcement.296

Jurisdictions where insider trading regulation is relatively unimportant also tend to have bank-dominated, as opposed to stock market-dominated, financial systems and a weaker separation of ownership and control. Hence, stock market liquidity is of less importance there.297 Arguably, in these jurisdictions, minority investors are more hurt by direct wealth expropriation by managers and controlling shareholders than by insider trading. “[I]f self dealing is a mainstay of blockholder returns, then an

_______________________________________________________ 292 Utpal Bhattacharya & Hazem Daouk, The World Price of Insider Trading, 57 J. FIN. 75, 76 (2002). However, insider trading regulation and enforcement is a recent phenomenon in most countries. See id. at 77. Consequently, the decrease in the cost of equity could be due to other measures of investor protection, financial liberalization, and crackdown on direct self-dealing, although the study controls for some of these variables. See id. at 96-97. The authors themselves admit that they are “reluctant to attribute causality” among insider trading regulation and enforcement and the cost of equity. Id. at 104. 293 LAURA NYANTUNG BENY, THE POLITICAL ECONOMY OF INSIDER TRADING

LEGISLATION AND ENFORCEMENT: INTERNATIONAL EVIDENCE 39 (Harv. Law Sch., Ctr. for Law, Econ., and Bus., Discussion Paper No. 348, 2002). 294 See id. at 8-10, 14. This essentially follows the logic in Haddock & Macey, supra note 10. 295 MACEY, supra note 107, at 43-44. 296 See id. at 44. See also Paul G. Mahoney, Securities Regulation by Enforcement: An International Perspective, 7 YALE J. ON REG. 305, 315 (1990); James A. Kehoe, Recent Development, Exporting Insider Trading Laws: The Enforcement of U.S. Insider Trading Laws Internationally, 9 EMORY INT’L L. REV. 345, 352 (1995). 297 For the comparison of these two basic financial systems, see generally FRANKLIN

ALLEN & DOUGLAS GALE, COMPARING FINANCIAL SYSTEMS (2000).

146 CAPITAL UNIVERSITY LAW REVIEW [33:83 effective insider trading ban will not suffice to bring high liquidity. . . .”298 Some scholars even suggest that permitting insider trading may be beneficial for an emerging economy, which is unlikely to possess sophisticated security analysts, in order to improve price efficiency and allocation of capital.299 Yet, insider trading regulation may have some benefits for financial liberalization.300 “Since rampant insider trading in a nation’s markets often impairs the attractiveness of that market to foreign participants, competitive pressures may lead to adoption of laws prohibiting insider dealing or to stricter enforcement of existing laws.”301

B. Empirical Research on Insider Trading Regulation Empirical research is generally skeptical as to the effectiveness of

insider trading regulation.302 Thus, such regulation may affect the behavior _______________________________________________________

(continued)

298 William W. Bratton & Joseph A. McCahery, Comparative Corporate Governance and the Theory of the Firm: The Case Against Global Cross Reference, 38 COLUM. J. TRANSNAT’L. L. 213, 294-95 (1999). 299 See Jie Hu & Thomas H. Noe, The Insider Trading Debate, FED. RES. BANK

ATLANTA ECON. REV., 4th Quarter 1997, at 34, 44. 300 See Harvey L. Pitt & David B. Hardison, Games Without Frontiers: Trends in the International Response to Insider Trading, 55 LAW & CONTEMP. PROBS. 199, 202 (1992). 301 Id. 302 See Nasser Arshadi & Thomas H. Eyssell, Regulatory Deterrence and Registered Insider Trading: The Case of Tender Offers, FIN. MGMT., Summer 1991, at 30 (finding lower activity of registered insiders around tender offers in the United States after the passage of federal legislation in 1984, but positing that trading by outsiders with privileged access to corporate affairs is responsible for the persisting preannouncement price runups); Javier Estrada & J. Ignacio Peña, Empirical Evidence on the Impact of European Insider Trading Regulations, 20 STUD. ECON. & FIN. 12 (2002) (finding that insider trading regulation in ten European countries had little effect on their securities markets’ characteristics, such as cost of capital, mean returns, and volatility); David Hillier & Andrew P. Marshall, Are Trading Bans Effective? Exchange Regulation and Corporate Insider Transactions Around Earnings Announcements, 8 J. CORP. FIN. 393 (2002) (finding that the LSE’s ban on insider transactions around earnings announcements did not affect the overall profitability of these transactions); H. Nejat Seyhun, The Effectiveness of the Insider-Trading Sanctions, 35 J.L. & ECON. 149 (1992) (finding a secular increase in the profitability of transactions of registered insiders in the United States despite the tightening of insider trading regulation in the 1980’s); Arturo Bris, Do Insider Trading Laws Work? ii (Feb. 2003) (unpublished manuscript, on file with author) (presenting extensive cross-country evidence that “insider trading enforcement increases both the incidence and the profitability of insider trading”). But see Anthony Boardman et al., The Effectiveness of Tightening Illegal Insider Trading Regulation: The Case of Corporate Takeovers, 8 APPLIED FIN. ECON. 519, 520 (1998) (finding that “the tightening of regulation in the late 1980s [in the United States] was effective and significantly reduced illegal insider trading”

2004] INSIDER TRADING AND THE BID-ASK SPREAD 147 of certain categories of traders, but it does not eliminate profits from trading on private information, probably by shifting emphasis from legal to illegal trading or by transferring profits from corporate insiders to market professionals. Of course, to the extent market professionals provide market making services, insider trading regulation benefits them—but for a different reason than predicted by the adverse selection model.

There is evidence that questions the link between insider trading regulation and transaction costs. One study, using a sample of 412 NYSE-listed American Depositary Receipts (ADRs) from 44 countries, found no relationship between the enforcement of insider trading regulation and the bid-ask spread.303 Jan Hanousek and Richard Podpiera examined the Prague Stock Exchange, “known for being plagued by insider trading,”304 and found that the adverse selection component averages only at 17%.305 Although the explanation offered is that “[t]he limited size of the market and the growing experience of market makers allows them to discriminate among counterparties and, thus, lower their expected loss [caused by] informed trading,”306 this study gives reasons either to question that insider trading would substantially increase the bid-ask spread in an unregulated regime or to raise doubts about the methodological accuracy. On the other hand, Ana Christina Silva and Gonzalo Chavez estimate that the adverse

as the preannouncement price runups were found to be significantly lower after the passage of regulation); Jon A. Garfinkel, New Evidence on the Effects of Federal Regulations on Insider Trading, 3 J. CORP. FIN. 89 (1997) (finding that the tightening of the insider trading regulation in the 1980’s in the United States had an effect on registered insiders’ transactions around earnings announcements); Se-Jin Min, The Effectiveness of the Insider Trading Sanctions in the 1980s—The Case of Mergers and Acquisitions (Oct. 2002) (unpublished manuscript, on file with author) (finding that the tightening of insider trading regulation in the 1980’s in the United States curbed abnormal trading around merger and acquisition announcements in the aggregate but did not affect large transactions). 303 Venkat R. Eleswarapu & Kumar Venkataraman, The Impact of Legal and Political Institutions on Equity Trading Costs: A Cross-Country Analysis 3-4 (Mar. 2003) (unpublished manuscript, on file with author). However, this may be due to the fact that all ADRs are subject to the same NYSE disclosure standards that deter some amount of informed trading and smooth cross-country differences in the enforcement of insider trading regulation. 304 Jan Hanousek & Richard Podpiera, Informed Trading and the Bid-Ask Spread: Evidence from an Emerging Market, 31 J. COMP. ECON. 275, 276 (2003). 305 Id. at 295. A companion empirical study confirms that the probability of informed trading on the PSE is extremely high, averaging at 32%. See Jan Hanousek & Richard Podpiera, Information-Driven Trading at the Prague Stock Exchange: Evidence from Intra-Day Data, 10 ECON. TRANSITION 747 (2002). 306 Hanousek & Podpiera, supra note 304, at 295.

148 CAPITAL UNIVERSITY LAW REVIEW [33:83 selection component accounts for 95% of the bid-ask spreads for the stocks listed on the Mexican Stock Exchange (MSE).307

Besides, there is not much empirical evidence supporting the older argument that insider trading deters many potential investors from participating in equities markets or affects the trading volume. One legal commentator cited anecdotal evidence that insider trading regulation adopted by the Amsterdam Stock Exchange in 1986 led to an increase in the trading volume.308 Yet, later empirical research indicates that as a result of that particular regulation, “stocks became less liquid (when liquidity is measured by trading volume) [and] the stock market’s speed of adjustment to positive earnings news [was reduced].”309

C. Summary Thus, the correlation between market liquidity, which has more

dimensions than the bid-ask spread alone, and insider trading regulation does not offer definitive support for the adverse selection model. Furthermore, there is a wealth of empirical evidence indicating that market liquidity and the extent of external financing depends on the strength of legal protections offered to investors,310 which is likely to be correlated with the existence of insider trading regulation.

_______________________________________________________ 307 Ana Cristina Silva & Gonzalo Chavez, Components of Execution Costs: Evidence of Asymmetric Information at the Mexican Stock Exchange, 12 J. INT’L FIN. MARKETS, INST. & MONEY 253, 272 (2002). See also Uptal Bhattacharya et al., When an Event is not an Event: The Curious Case of an Emerging Market, 55 J. FIN. ECON. 69 (2000) (offering empirical evidence suggesting that insider trading in MSE stocks is widespread). 308 Merritt B. Fox, Insider Trading in a Globalizing Market: Who Should Regulate What?, 55 LAW & CONTEMP. PROBS. 263, 274 n.22 (1992). But see Laura Nyantung Beny, Do Insider Trading Laws Matter? Some Preliminary Comparative Evidence, 7 AM. L. &

ECON. REV. (forthcoming 2005) (examining possible links between insider trading regulation and enforcement, on one hand, and equity ownership diffusion, stock price accuracy, and market liquidity, on the other). 309 Rezaul Kabir & Theo Vermaelen, Insider Trading Restrictions and the Stock Market: Evidence from the Amsterdam Stock Exchange, 40 EUR. ECON. REV. 1591, 1591 (1996). 310 See, e.g., Rafael La Porta et al., Legal Determinants of External Finance, 52 J. FIN. 1131 (1997); Rafael La Porta et al., What Works in Securities Laws?, 60 J. FIN. (forthcoming 2005); Franco Modigliani & Enrico Perotti, Protection of Minority Interest and the Development of Security Markets, 18 MANAGERIAL & DECISION ECON. 519 (1997).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 149

XI. EMPIRICAL EVIDENCE ON THE LINK BETWEEN INSIDER TRADING AND LIQUIDITY

A. Types of Studies and Components of the Bid-Ask Spread The adverse selection model generated numerous empirical studies that

dealt with the decomposition of the bid-ask spread, the behavior of the spread in time, the relationship between disclosed insiders’ transactions or holdings and the spread, and the effect of insider trading on the market depth.311

Most decomposition studies distinguish the order processing, inventory holding, and adverse selection components of the bid-ask spread.312 The order processing component includes “the costs of labor and capital needed to provide quote information, order routing, execution, and clearing.”313 The inventory holding component reflects the risks and opportunity costs of carrying large holdings and the exposure to adverse price movements and increases with the security’s illiquidity and volatility.314 Making a market in infrequently traded stocks implies a greater inventory risk because of a longer average holding period, more frequent order mismatches, and a demand for more inventory.315 Another component of the spread can be non-competitive pricing.316 Empirical evidence does suggest that in dealer markets, the number of market makers317 or the extent of outside competition in providing liquidity offered by institutional

_______________________________________________________ 311 Additionally, there is some evidence from experimental markets that supports the adverse selection model. See Robert Bloomfield, Quotes, Prices, and Estimates in a Laboratory Market, 51 J. FIN. 1791, 1791-92 (1996); Jan Pieter Krahnen & Martin Weber, Marketmaking in the Laboratory: Does Competition Matter?, 4 EXPERIMENTAL ECON. 55, 80 (2001). 312 STOLL, supra note 171, at 39. 313 Stoll, supra note 23, at 563. 314 Id. at 563-66. 315 See Tinic, supra note 147, at 81. Some also suggest that the inventory cost may depend on the degree of diversification of the market maker’s portfolio. Id. at 82-83. Although, one theoretical model argued that “portfolio diversification against return risk is irrelevant for the level of the spread.” STOLL, supra note 171, at 26. See also Salil K. Sarkar & Niranjan Tripathy, An Empirical Analysis of the Impact of Stock Index Futures Trading on Securities Dealers’ Inventory Risk in the NASDAQ Market, 11 REV. FIN. ECON. 1, 15-16 (2002) (offering empirical evidence that the use of stock index futures decreased the inventory risk for the NASDAQ market makers and resulted in lower bid-ask spreads). 316 See Demsetz, supra note 27, at 43-45; STOLL, supra note 171, at 39, 40. 317 Mark Klock & D. Timothy McCormick, The Impact of Market Maker Competition on Nasdaq Spreads, FIN. REV., Nov. 1999, at 55, 56; Sunil Wahal, Entry, Exit, Market Makers, and the Bid-Ask Spread, 10 REV. FIN. STUD. 871, 872 (1997).

150 CAPITAL UNIVERSITY LAW REVIEW [33:83 investors318 is negatively related to the bid-ask spread.319 The spread also depends on the minimum price increment, known as the “tick size.”320

B. Spread Decomposition Studies The empirical studies, summarized below, attempted to decompose the

spread. GLOSTEN AND HARRIS 1988321

• A sample of 20 NYSE stocks is used;322

_______________________________________________________ 318 Paul A. Laux, Dealer Market Structure, Outside Competition, and the Bid-Ask Spread, 19 J. ECON. DYNAMICS & CONTROL 683, 684 (1995). 319 Some studies also argued that there are “common” or “systematic” factors that determine liquidity in individual stocks. See Tarun Chordia et al., Commonality in Liquidity, 56 J. FIN. ECON. 3 (2000); Gur Huberman & Dominika Halka, Systematic Liquidity, 24 J. FIN. RES. 161 (2001). 320 See, e.g., V. Ravi Anshuman & Avner Kalay, Market Making with Discrete Prices, 11 REV. FIN. STUD. 81, 82 (1998). The tick size determines the price grid and hence influences the bid and ask quotations. See, e.g., Fred Merkel, One Small Tick Can Make a Big Difference, FIN. TIMES (London), June 12, 2001, at 29. A mandated minimum price increment “could be used by market makers to recoup fixed costs [or] serve as a credible mechanism for enforcing a cartel-like agreement.” Anshuman & Kalay, supra, at 83. There are reasons to believe that there should be some optimal minimum price increment, as a very small tick size may impose costs on market makers and impair other dimensions of market liquidity. See Merkel, supra. “A minimum tick is required in an auction market to encourage liquidity provision by limit orders and by dealers. Without a minimum tick (or a minimum trade size), a limit order can cheaply step ahead of another limit order or a dealer quote.” Huang & Stoll, supra note 202, at 520. For empirical evidence on the effects of reducing the tick size, see Hee-Joon Ahn et al., Tick Size, Spread, and Volume, 5 J. FIN. INTERMEDIATION 2 (1996) (finding a reduction in spreads and no change in the trading volume or depths on the AMEX); Jeffrey M. Bacidore, The Impact of Decimalization on Market Quality: An Empirical Investigation of the Toronto Stock Exchange, 6 J. FIN. INTERMEDIATION 92 (1997) (finding a decrease in spreads and depths but no change in the trading volume on the Toronto Stock Exchange); Bonnie F. Van Ness et al., The Impact of the Reduction in Tick Increments in Major U.S. Markets on Spreads, Depth, and Volatility, 15 REV. QUANTITATIVE FIN. & ACCT. 153 (2000) (finding a reduction in spreads and depths on the NYSE and AMEX and a reduction in spreads and an increase in depths on the NASDAQ). 321 Lawrence R. Glosten & Lawrence E. Harris, Estimating the Components of the Bid/Ask Spread, 21 J. FIN. ECON. 123 (1988). 322 Id. at 131-32.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 151 • The spread is decomposed into the transitory component,

incorporating “inventory costs, clearing fees, and/or monopoly profits” and the adverse selection component;323

• With price discreteness ignored, the adverse selection component comprises 20% of the spread; with discreteness considered, the adverse selection component comprises 35%.324

STOLL 1989325

• Samples of NASDAQ stocks (varying from 765 to 821 stocks) are used;326

• The spread is decomposed into the order processing, inventory holding, and adverse information components;327

• The adverse information component is estimated at 43%, the inventory holding component at 10%, and the order processing component at 47%;328

• “While the quoted spread varies considerably across stocks, the components of the spread appear to be an invariant proportion of the quoted spread.”329

VIJH 1990330

• A sample of 20 most actively traded CBOE options is used;331

• The spread is decomposed into the “transitory” and “adverse-selection” components;332

_______________________________________________________ 323 Id. at 123-24. 324 Id. at 136. 325 Hans R. Stoll, Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests, 44 J. FIN. 115 (1989). 326 Id. at 123. 327 Id. at 115. 328 Id. at 129. 329 Id. at 132. 330 Vijh, supra note 282. 331 Id. at 1172. 332 Id. at 1171.

152 CAPITAL UNIVERSITY LAW REVIEW [33:83 • The “adverse-selection” component was estimated at 2%.333

GEORGE, KAUL, AND NIMALENDRAN 1991334

• Samples of AMEX, NYSE, and NASDAQ stocks of unspecified size are used;335

• The spread is decomposed into the order processing and adverse selection components;336

• The adverse selection component is estimated to comprise from 8% to 13% of the spread;337

• “No evidence for the existence of an inventory cost component” is found because of positive “autocorrelation in returns based on bid (or ask) quotes.”338

AFFLECK-GRAVES, HEDGE, AND MILLER 1994339

• Samples of 1,648 “exchange stocks” (1,350 listed on NYSE and 298 listed on AMEX) and 815 NASDAQ and NMS stocks are used;340

• The methodologies in Stoll 1989 and George, Kaul, and Nimalendran 1991 are used;341

• Using the Stoll 1989 methodology, the adverse selection component is 50% and 36%, the inventory holding component is 48% and 17%, and the order processing component is 1% and 47% for NYSE/AMEX and NASDAQ/NMS stocks, respectively;342

_______________________________________________________ 333 Id. at 1177. 334 Thomas J. George et al., Estimation of the Bid-Ask Spread and Components: A New Approach, 4 REV. FIN. STUD. 623 (1991). 335 Id. at 632. 336 Id. at 625. 337 Id. at 623. 338 Id. at 649. 339 Affleck-Graves et al., supra note 192. 340 Id. at 1475. 341 Id. at 1476. 342 Id. at 1481.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 153 • Using the George, Kaul, and Nimalendran 1991 methodology,

the adverse selection component is 29% and 10%, and the order processing component is 71% and 90% for NYSE/AMEX and NASDAQ/NMS stocks, respectively.343

BROOKS 1994344

• Samples of 90 NYSE and AMEX stocks around dividend and earnings announcements are used;345

• The spread is decomposed into “a fixed (execution) component and an adverse selection component [that also includes the inventory component]”;346

• Spreads are significantly higher around earnings announcements;347

• The adverse selection component for the full sample comprises 48% of the spread.348

LIN, SANGER, AND BOOTH 1995349

• A sample of 150 NYSE stocks is used;350

• The spread is assumed to consist of the “adverse information costs component” and the “order processing costs component,” and the inventory holding component is said to be negligible;351

_______________________________________________________ 343 Id. at 1483. 344 Raymond M. Brooks, Bid-Ask Spread Components Around Anticipated Announcements, 17 J. FIN. RES. 375 (1994). 345 Id. at 376. 346 Id. at 375. 347 Id. at 385. 348 Id. at 380. 349 Ji-Chai Lin et al., Trade Size and Components of the Bid-Ask Spread, 8 REV. FIN. STUD. 1153 (1995). 350 Id. at 1158-59. 351 Id. at 1154.

154 CAPITAL UNIVERSITY LAW REVIEW [33:83 • The adverse selection component varies from 20% to 63%

depending on the trade size.352

DE JONG, NIJMAN, AND RÖELL 1996353

• A sample of 10 stocks of large companies traded on the Paris Bourse, where liquidity is provided by public limit orders matched by an automatic system, not by specialists or dealers, is used;354

• The spread is decomposed into the adverse selection and order processing components;355

• The adverse selection component is estimated to be between 30% and 45%.356

KIM AND OGDEN 1996357

• Samples of 1,871 NYSE and AMEX stocks are used;358

• The spread is assumed to consist of the order processing and adverse selection components,359 although the former may capture the inventory holding component;360

• The adverse selection component is estimated to be between 45% and 54%.361

_______________________________________________________ 352 Id. at 1165. 353 Frank de Jong et al., Price Effects of Trading and Components of the Bid-Ask Spread on the Paris Bourse, 3 J. EMPIRICAL FIN. 193 (1996). 354 Id. at 196. 355 Id. at 200. 356 Id. at 210. 357 Sung-Hun Kim & Joseph P. Ogden, Determinants of the Components of Bid-Ask Spreads on Stocks, 1 EUR. FIN. MGMT. 127 (1996). 358 Id. at 133. 359 Id. at 127-28. 360 Id. at 129. 361 Id. at 137.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 155

KRINSKY AND LEE 1996362

• A sample of 506 and 511 “firm/quarter earnings announcements” for two subsequent years for companies listed on the NYSE and AMEX is used;363

• The spread is decomposed into the adverse selection, inventory holding, and order processing components;364

• The adverse selection component varies from 60% to 76% during the predisclosure and event periods, compared to 47% during the benchmark period;365

• The change in the absolute bid-ask spread is ambiguous, as announcements are typically associated with a greater trading volume, which allows market makers to decrease the price of immediacy.366

PORTER AND WEAVER 1996367

• Samples of 880 NYSE, 107 AMEX, and 289 NASDAQ stocks are used; the sample from each market is divided into four portfolios depending on the average transaction price;368

• The methodology in George, Kaul, and Nimalendran 1991 is used;369

• The adverse selection component varies from 0 to 51% for the NYSE stocks, from 17 to 46% for the AMEX stocks, and from 0 to 24% for the NASDAQ stocks.370

_______________________________________________________ 362 Krinsky & Lee, supra note 113. 363 Id. at 1528. 364 Id. at 1523. 365 Id. at 1532. 366 Id. at 1534. 367 David C. Porter & Daniel G. Weaver, Estimating Bid-Ask Spread Components: Specialist Versus Multiple Market Maker Systems, 6 REV. QUANTITATIVE FIN. & ACCT. 167 (1996). 368 Id. at 174. 369 Id. at 168. 370 Id. at 175.

156 CAPITAL UNIVERSITY LAW REVIEW [33:83 HUANG AND STOLL 1997371

• A sample of 20 NYSE stocks selected among “the largest and the most actively traded stocks” is used;372

• The spread is decomposed into the adverse selection, inventory holding, and order processing components;373

• The adverse selection component, when lumped with the inventory holding component, comprises from 2% to 22% of the spread,374 averaging at 11%;375

• When the adverse selection and inventory holding components are separated and adjusted, the former averages at 10%, and the latter averages at 29%.376

MADHAVAN, RICHARDSON, AND ROOMANS 1997377

• A sample of 274 NYSE stocks is used;378

• The model estimates the “information asymmetry parameter” and the “transaction” component that includes the inventory risk;379

• “[T]he [mean] fraction of the implied spread attributable to asymmetric information” varies throughout the day from 36% to 51%.380

_______________________________________________________ 371 Roger D. Huang & Hans R. Stoll, The Components of the Bid-Ask Spread: A General Approach, 10 REV. FIN. STUD. 995 (1997). 372 Id. at 1005. 373 Id. at 995-96. 374 Id. at 1009. 375 Id. 376 Id. at 1020. 377 Ananth Madhavan et al., Why Do Security Prices Change? A Transaction-Level Analysis of NYSE Stocks, 10 REV. FIN. STUD. 1035 (1997). 378 Id. at 1043. 379 Id. at 1045-46. 380 Id. at 1048.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 157

LIN, SANGER, AND BOOTH 1998381

• Samples of 150 NMS and NASDAQ stocks matched with 150 NYSE stocks are used;382

• The bid-ask spread is decomposed into the “dealer’s gross spread [that] represents compensation for inventory holding costs, order processing costs and other fixed costs including external information costs” and the adverse selection component;383

• For the NYSE stocks, the adverse selection component varies from 12% to 56%, depending on the trade size; for the NMS/NASDAQ stocks, the adverse selection component varies from 0% to 5%;384

• The divergence between the NASDAQ and the NYSE is rationalized on the grounds that “NASDAQ market making firms conduct information search and security analysis which reduces or eliminates the informational disadvantage . . . . NYSE specialist firms do not typically engage in such analysis, and NYSE regulations prevent the transfer of information to the specialist from the analyst if the firm does perform both functions.”385

BROCKMAN AND CHUNG 1999386

• A sample of 345 companies listed on the Stock Exchange of Hong Kong where liquidity is provided by public limit orders matched by an automatic system, not by specialists or dealers, is used;387

_______________________________________________________ 381 Lin et al., supra note 205. 382 Id. at 119-20. 383 Id. at 121. 384 Id. at 124. 385 Id. at 132. 386 Paul Brockman & Dennis Y. Chung, Bid-Ask Spread Components in an Order-Driven Environment, 22 J. FIN. RES. 227 (1999). 387 Id. at 230.

158 CAPITAL UNIVERSITY LAW REVIEW [33:83 • The spread is decomposed into the adverse selection and order

processing components;388

• The median adverse selection component is estimated at 33%, and the median order processing component at 45%.389

KIM AND DILTZ 1999390

• Samples of 118 NYSE and AMEX stocks, where options contracts were introduced, are used;391

• The Stoll 1989 methodology is used;392

• For the pre-option listing period, the adverse selection component is 84%, the inventory holding component is 8%, and the order processing component is 8%; for the post-option listing period, these figures are 78%, 12%, and 10%, respectively;393

• The results were interpreted as suggesting that “option trading shifts informed traders into the option market and reduces the information gap between market makers and traders in the stock market.”394

WANG 1999395

• A sample of three different futures contracts traded on the Sydney Futures Exchange is used;396

• The Stoll 1989 methodology is used;397

• Depending on the type of futures contract and the type of the trading system, the adverse selection component varies from

_______________________________________________________ 388 Id. at 229. 389 Id. at 237-40. 390 Kim & Diltz, supra note 278. 391 Id. at 399. 392 Id. at 397. 393 Id. at 404. 394 Id. at 409. 395 Wang, supra note 285. 396 Id. at 121. 397 Id. at 125.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 159 17% to 56%, the order processing component from 6% to 26%, and the inventory component from 34% to 69%.398

MENYAH AND PAUDYAL 2000399

• A sample of 819 stocks listed on the LSE is used;400

• The Stoll 1989 methodology is used;401

• The order processing component is 30%, the inventory holding component is 23%, and the adverse selection component is 47%.402

WESTON 2000403

• A sample of 88 NASDAQ stocks is used;404

• The spread is decomposed into two categories: (1) inventory and adverse selection costs and (2) order processing costs and economic rents;405

• The inventory and adverse selection costs are estimated at 4% before the NASDAQ reform and 7% thereafter.406

LEE AND YI 2001407

• Samples of 47 NYSE stocks and CBOE options based on these stocks are used;408

• The spread is decomposed into the adverse selection component and the “realized half-spread”;409

_______________________________________________________ 398 Id. 399 Kojo Menyah & Krishna Paudyal, The Components of the Bid-Ask Spreads on the London Stock Exchange, 24 J. BANKING & FIN. 1767 (2000). 400 Id. at 1773. 401 Id. at 1775. 402 Id. at 1781. 403 Weston, supra note 203. 404 Id. at 2573. 405 Id. at 2574. 406 Id. 407 Lee & Yi, supra note 269. 408 Id. at 489-90.

160 CAPITAL UNIVERSITY LAW REVIEW [33:83 • The average adverse selection component is 38% for options

and 70% for stocks, although, in absolute terms, the options’ spread and adverse selection component are larger; for small trades, the adverse selection component is larger for options than for stocks, while the opposite is true for large trades.410

COUGHENOUR AND DELI 2002411

• A sample of 120 NYSE stocks is used;412

• The adverse selection component of the spread is estimated from the price impact of individual trades;413

• The average adverse selection component varies between 59% and 64%, depending on whether the specialist firm is employee- or publicly-owned.414

MCINISH AND VAN NESS 2002415

• A sample of 30 NYSE stocks in the Dow Jones Industrial Average is used;416

• The spread is decomposed into the order processing and adverse selection components;417

• The methodologies in George, Kaul, and Nimalendran 1991 and Madhavan, Richardson, and Roomans 1997 are used;418

• The adverse selection component is 40% and 54% using the George, Kaul, and Nimalendran 1991 and Madhavan,

409 Id. at 495-96. 410 Id. at 496. 411 Jay F. Coughenour & Daniel N. Deli, Liquidity Provision and the Organizational Form of NYSE Specialist Firms, 57 J. FIN. 841 (2002). 412 Id. at 854. 413 Id. at 848. 414 Id. at 856. 415 Thomas H. McInish & Bonnie F. Van Ness, An Intraday Examination of the Components of the Bid-Ask Spread, 37 FIN. REV. 507 (2002). 416 Id. at 511. 417 Id. at 508. 418 Id.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 161 Richardson, and Roomans 1997 methodologies, respectively.419

SILVA AND CHAVEZ 2002420

• This study uses a sample of 37 issues of 29 corporations, chosen from the most actively traded stocks on the MSE and matched with similar stocks on the NYSE;421

• The Stoll 1989 methodology is used;422

• For the MSE stocks, the adverse selection component is 95%, the inventory component is 4%, and the order processing component is 1%; for the NYSE stocks, the components are 52%, 33%, and 15%, respectively;423

• The average bid-ask spread, expressed as a percentage of the stock price, is five times larger for the MSE stocks.424

DE WINNE AND PLATTEN 2003425

• A sample of 30 stocks on “Nasdaq Europe” is used;426

• The methodologies in Lin, Sanger, and Booth 1995 and Huang and Stoll 1997 are used;427

• The “adverse selection” component is 1% for the Lin, Sanger, and Booth 1995 methodology428 and negative for the Huang and Stoll 1997 methodology;429

• The inventory control effect is also found.430 _______________________________________________________ 419 Id. at 518. 420 Silva & Chavez, supra note 307. 421 Id. at 260. 422 Id. at 263. 423 Id. at 265. 424 Id. at 272. 425 Rudy De Winne & Isabelle Platten, An Analysis of Market Makers’ Behavior on Nasdaq Europe (Jan. 8, 2003) (unpublished manuscript, on file with author). 426 Id. at 3. 427 Id. at 8-10. 428 Id. at 10. 429 Id. at 8.

162 CAPITAL UNIVERSITY LAW REVIEW [33:83 HANOUSEK AND PODPIERA 2003431

• A sample of 10 stocks listed on the Prague Stock Exchange is used;432

• The bid-ask spread is decomposed into the order processing, inventory, and adverse selection components;433

• The order processing component averages at 77%, the inventory component at 6%, and the adverse selection component at 17%.434

These studies varied in their assessment of the magnitude of adverse selection, even for very similar samples, but many of them attributed a large portion of the spread to the risk of informed trading, despite the existence of regulation in most samples.435

C. Event Studies of Insider Trading The above-mentioned decomposition studies relied on econometric

techniques to estimate all informed trading—trading on the basis of both “inside” and fundamental and non-fundamental “outside” information—by looking at quote revisions, changes in volume, and sequential correlations of trades, instead of using a more direct proxy.436 Some studies overcame

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430 Id. at 11-13. 431 Hanousek & Podpiera, supra note 304. 432 Id. at 278. 433 Id. at 288. 434 Id. at 293. 435 However, the statement by the NYSE Specialist Association that insider trading is not a matter of concern for their market making activities casts doubts on the studies arguing that the insider trading risk accounts for a large portion of the bid-ask spread for NYSE stocks. See McGee, supra note 118, at C20. 436 For a critique of econometric estimation of the bid-ask spread components, see Clifford A. Ball & Tarun Chordia, True Spreads and Equilibrium Prices, 56 J. FIN. 1801, 1803 (2001) (finding that “the effect of rounding on quoted spreads is larger than all the other components of the spread combined”); Raymond Brooks & Jean Masson, Performance of Stoll’s Spread Component Estimator: Evidence from Simulations, Time-Series, and Cross-Sectional Data, 19 J. FIN. RES. 459, 459 (1996) (finding that some of the bid-ask spreads’ estimators are “severely biased and highly unreliable in short-time series and small cross-sectional samples”); Hasung Jang & P.C. Venkatesh, Consistency Between Predicted and Actual Bid-Ask Quote-Revisions, 46 J. FIN. 433, 445 (1991) (finding that “observed quote-revisions are inconsistent with the theoretical predictions [of adverse

2004] INSIDER TRADING AND THE BID-ASK SPREAD 163 this methodological problem by looking at the precise information on illegal insider trading in some individual companies.437

Bradford Cornell and Erik R. Sirri examined insider trading in shares of Campbell Taggart before its acquisition and concluded that “market liquidity [measured by the bid-ask spread] actually rose while the insiders were trading,” probably due to the increased speculative interest of uninformed traders, and that the share price rose, directly contradicting the adverse selection model.438 A very similar study looked at insider trading by Ivan Boesky in the stock of Carnation Company before its acquisition.439 The results were nearly identical: the share price rose, the bid-ask spread did not change, and the market depth increased, giving grounds for the conclusion that “insider trading appears to facilitate price discovery and to have no adverse effect on market liquidity.”440 However, the counter-criticism may be that “[e]ven if bid-ask spreads do not widen in immediate response to particular instances of insider trading, spreads may widen generally because insider trading decreases the profits of market makers over time.” 441

D. Time-Varying Studies of the Spread It has been argued that widening spreads near corporate

announcements, when insider trading is relatively common and profitable, constitutes evidence of adverse selection.442 However, this may also be

(continued)

selection and inventory cost models of bid-ask spreads] for more than 75% of the observations”). 437 Bradford Cornell & Erik R. Sirri, The Reaction of Investors and Stock Prices to Insider Trading, 47 J. FIN. 1031, 1032 (1992). 438 Id. at 1032. 439 Sugato Chakravarty & John J. McConnell, An Analysis of Prices, Bid/Ask Spreads, and Bid and Ask Depths Surrounding Ivan Boesky’s Illegal Trading in Carnation’s Stock, FIN. MGMT., Summer 1997, at 18. 440 Id. at 19. 441 Wang, supra note 87, at 883 n.70. 442 For surveys of empirical research that documented widening bid-ask spreads around dividend, earnings, stock repurchase, and corporate acquisition announcements, see Kee H. Chung & Charlie Charoenwong, Insider Trading and the Bid-Ask Spread, FIN. REV., Aug. 1998, at 1, 2; Lee et al., supra note 113, at 353-55. Some studies found an increase in spreads around stock repurchases as possible signals of private information and suggested that it may be due to the adverse selection cost. See Paul Brockman & Dennis Y. Chung, Managerial Timing and Corporate Liquidity: Evidence from Actual Share Repurchases, 61 J. FIN. ECON. 417, 445 (2001); Diana R. Franz et al., Informed Trading Risk and Bid-Ask Spread Changes Around Open Market Stock Repurchases in the NASDAQ Market, 18 J. FIN. RES. 311 (1995); Ajai K. Singh et al., Liquidity Changes Associated with Open Market Repurchases, FIN. MGMT., Spring 1994, at 47, 53. For studies that found no evidence of

164 CAPITAL UNIVERSITY LAW REVIEW [33:83 explained by greater market uncertainty regarding the security’s price in the near future. It is not necessarily insider trading itself, but the possibility of a sudden price movement that widens the spread to compensate the market maker for additional inventory risk. This is exactly what one of the earliest empirical studies discussed:

Risk-averse dealers with nondiversified portfolios are adversely affected by higher price variances. Any information signal release may increase the price variance and place the dealer in a riskier position. To compensate for this riskier position, the dealer may increase the bid/ask spread. Another reason for the effect of information on bid/ask spreads is the potential for investors to trade on private information. . . . A dealer may increase the bid/ask spread in an attempt to compensate for trading with privately-informed investors.443

The phenomenon of trading halts on exchanges444 was also cited in support of the model: “[a]dverse selection fears caused by asymmetrical information seems to be an important cause for suspensions that are triggered by firms announcing impending news.”445 But it is unclear whether this is caused by actual insider trading or increased volatility and time necessary for processing new information. Even though the insider trading explanation for widened spreads seems plausible when opportunities to rebalance the market maker’s inventory are limited, volatility may also explain trading halts. The NYSE halts, in particular,

widening spreads around stock repurchases, see Hee-Joon Ahn et al., Share Repurchase Tender Offers and Bid-Ask Spreads, 25 J. BANKING & FIN. 445 (2001); James M. Miller & John J. McConnell, Open-Market Share Repurchase Programs and Bid-Ask Spreads on the NYSE: Implications for Corporate Payout Policy, 30 J. FIN. & QUANTITATIVE ANALYSIS 365 (1995); James B. Wiggins, Open Market Stock Repurchase Programs and Liquidity, 17 J. FIN. RES. 217 (1994). Scholars also suggest that, in some instances, repurchases, instead of conveying valuable information, may aid managers in transferring wealth from public shareholders to themselves. See Jesse M. Fried, Open Market Repurchases: Signaling or Managerial Opportunism, 2 THEORETICAL INQUIRIES L. 865, 893-94 (2001). 443 Morse & Ushman, supra note 45, at 257. 444 For a review of research pertaining to trading halts, see Charles M.C. Lee et al., Volume, Volatility, and New York Stock Exchange Trading Halts, 49 J. FIN. 183, 187-89 (1994). 445 Utpal Bhattacharya & Matthew Spiegel, Anatomy of a Market Failure: NYSE Trading Suspensions (1974-1988), 16 J. BUS. & ECON. STAT. 216, 226 (1998).

2004] INSIDER TRADING AND THE BID-ASK SPREAD 165 may be caused by the price continuity rule imposed on the specialists that is difficult to implement during the periods of extreme volatility.446

A related issue is the intraday pattern of bid-ask spreads, which is often “U-shaped,” with spreads peaking at the open and the close.447 This was interpreted as evidence for the adverse selection model, as informed trades are allegedly concentrated in the beginning and the end of the trading period in order to exploit information that has developed before the start of trading or which would be disclosed after the end of trading.448 However, a “U-shaped” pattern may emerge even without information-based trading, as it may be explained by a less elastic demand for immediacy at the open and the close for the following reasons:

First, the accumulation of overnight information in the absence of an opportunity to trade means that portfolios at the open have in general deviated from optimal holdings, resulting in opening trade to reestablish optimal portfolios. Second, in preparation for an overnight nontrading period, the optimal portfolios at the close will differ from those that are optimal during the continuous trading interval.449

E. Disclosed Insider Transactions and Holdings and the Spread

An alternative approach to measuring the magnitude of adverse selection considered relationships between the spread and disclosed insiders’ transactions or holdings.450 H. Nejat Seyhun looked at a sample of 769 publicly held companies451 and accepted the adverse selection argument452 on the basis of the correlation between the profitability of legal

_______________________________________________________ 446 See id. at 218. 447 See Christopher K. Ma et al., Trading Noise, Adverse Selection, and Intraday Bid-Ask Spreads in Futures Markets, 12 J. FUTURES MARKETS 519, 520 (1992). 448 See id. at 531. 449 William A. Brock & Allan W. Kleidon, Periodic Market Closure and Trading Volume: A Model of Intraday Bids and Asks, 16 J. ECON. DYNAMICS & CONTROL 451, 452 (1992). 450 Arguably, even disclosed trading by corporate insiders could yield abnormal profits. See SEYHUN, supra note 235; Leslie A. Jeng et al., Estimating the Returns to Insider Trading: A Performance-Evaluation Perspective, 85 REV. ECON. & STAT. 453 (2003); Bin Ke et al., What Insiders Know About Future Earnings and How They Use It: Evidence from Insider Trades, 35 J. ACCT. & ECON. 315 (2003); Richardson Pettit & P.C. Venkatesh, Insider Trading and Long-Run Return Performance, FIN. MGMT., Summer 1995, at 88. 451 Seyhun, supra note 234, at 192. 452 Id. at 191-92.

166 CAPITAL UNIVERSITY LAW REVIEW [33:83 insider trading and spreads.453 The study also documented the relationship between the profitability of disclosed trades and firm size,454 as well as the relationship between firm size and the spread,455 which may posit an alternative causal link. Raymond Chiang and P.C. Venkatesh looked at 63 NYSE firms and found a positive relationship between the size of insider holdings and the spread, controlling for firm size.456 Omesh Kini and Shehzad Mian found no relationship between the bid-ask spread and legal insider trading for a sample of 1,063 NYSE companies.457 Kee H. Chung and Charlie Charoenwong documented a positive relation between the magnitude and direction of legal insider trading and the spread for 1,101 AMEX and NYSE companies.458 Atulya Sarin, Karen A. Shastri, and Kuldeep Shastri confirmed a positive relation between the bid-ask spread, the adverse selection component, and insider holdings, examining 786 AMEX and NYSE stocks.459

J.C. Bettis, J.L. Coles, and M.L. Lemmon used a sample of 626 firms to identify corporate insider trading policies, especially the existence of “blackout” periods when insiders are prohibited from trading.460 When such a “blackout” period rule is in effect, the spread was found to be lower by two basis points than during the period when insiders are allowed to trade.461 This constitutes evidence in favor of the adverse selection model since “blackout” periods, typically occurring around earnings announcements, are generally characterized by higher price volatility, and one would expect higher spreads during that time.462 A related study by _______________________________________________________

(continued)

453 Id. at 201. 454 Id. 455 Id. at 199. 456 Raymond Chiang & P.C. Venkatesh, Insider Holdings and Perceptions of Information Asymmetry: A Note, 43 J. FIN. 1041, 1047 (1988). 457 Omesh Kini & Shehzad Mian, Bid-Ask Spread and Ownership Structure, 18 J. FIN. RES. 401, 413 (1995). 458 Chung & Charoenwong, supra note 442, at 3, 17. Yet, this study acknowledged that both the bid-ask spread and legal insider trading are correlated with firm size. Id. at 7-8. This study also found no substantial variation in spreads during the actual periods of trading by insiders. Id. at 17. 459 Atulya Sarin et al., Ownership Structure and Stock Market Liquidity 20 (Nov. 2000) (unpublished manuscript, on file with author). 460 See J.C. Bettis et al., Corporate Policies Restricting Trading by Insiders, 57 J. FIN. ECON. 191, 195 (2000). 461 Id. at 211. 462 This study also controlled for variables that might affect the bid-ask spread, such as firm size, volume, volatility, type of exchange, and share price. Id. The study also concluded that prohibiting insiders from trading during “blackout” periods does not “reduce liquidity for the firm’s shares.” Id. at 214. Overall, the study maintained that “blackout

2004] INSIDER TRADING AND THE BID-ASK SPREAD 167 Charles Cao, Laura Casares Field, and Gordon Hanka found no adverse change in the bid-ask spread and an improvement in the market depth after the expiration of IPO lockup provisions—when pre-IPO shareholders, typically, managers or venture capitalists, are allowed to trade, possibly on inside information—for 1,497 NYSE and NASDAQ companies, even after controlling for the increased float size.463 In contrast, Christopher K. Dussold and Clifford P. Stephens found an increase in the adverse selection component after the expiration of lockup provisions; however, they still documented an overall decrease in the bid-ask spread due to the injection of additional shares.464

F. Ownership Concentration, Investor Activism, and the Spread Some studies linked ownership concentration and investor activism to

bid-ask spreads on the grounds that an activist shareholder, institutional investor, or blockholder may engage in information-based trading by having privileged access to corporate affairs or enjoying the economies of scale in security analysis.465 Frank Heflin and Kenneth W. Shaw documented that the adverse selection component of the spread is related to the incidence of blockholding.466 Patrick J. Dennis and James P. Weston found that the bid-ask spread is negatively related to the extent of periods are associated with a modest reduction in the adverse selection component of the spread.” Id. But do such compliance programs exist because companies have “an incentive to voluntary regulate ‘insiders’ in order to reduce the bid-ask spread and consequently [their] opportunity cost of capital”? Amihud & Mendelson, Liquidity and Asset Prices, supra note 99, at 11. Or is it because companies want to avoid the legal liability for insider trading by their employees? See Marc I. Steinberg & John Fletcher, Compliance Programs for Insider Trading, 47 SMU L. REV. 1783, 1829-30 (1994). There is practically no evidence that the adverse selection concern motivated such programs. 463 Charles Cao et al., Does Insider Trading Impair Market Liquidity? Evidence from IPO Lockup Expirations, 39 J. FIN. & QUANTITATIVE ANALYSIS 25, 26 (2004). “The simplest interpretation for our results . . . is that expected losses due to insider trading are small relative to other costs of making a market, and hence have little effect on spreads and quote depth.” Id. at 44. 464 Christopher K. Dussold & Clifford P. Stephens, The Microstructure Effects of Lockup Expirations 22 (Jan. 2003) (unpublished manuscript, on file with author). 465 One theoretical work similarly posited that “strategic ownership can either raise or lower spreads,” balancing between increased informed trading and better monitoring that reduces uncertainty. Thomas H. Noe, Investor Activism and Financial Market Structure, 15 REV. FIN. STUD. 289, 292 (2002). The caveat is that many block transactions are traded directly with an aid of a block broker or an electronic communication network (ECN) rather than through a market maker. 466 See Frank Heflin & Kenneth W. Shaw, Blockholder Ownership and Market Liquidity, 35 J. FIN. & QUANTITATIVE ANALYSIS 621, 632 (2000).

168 CAPITAL UNIVERSITY LAW REVIEW [33:83 institutional ownership, but that the adverse selection component of the spread is positively related to institutional ownership.467 The explanation given is that “[w]hile the market maker may widen the spread when trading with institutions, institutions prefer stocks with narrower spreads since they are more liquid.”468

Malay K. Dey and B. Radhakrishna similarly documented a positive relation between the intensity of institutional trading and the adverse selection component and an overall negative relation between institutional trading and the total spread size.469 Sergey S. Barabanov and Michael J. McNamara also confirmed that the level of institutional ownership is negatively related to the bid-ask spread, but posited that the concentration of institutional ownership is positively related to the spread.470 Atulya Sarin, Karen A. Shastri, and Kuldeep Shastri found a negative correlation between institutional ownership and the bid-ask spread, as well as the market depth, but suggested a different reason for that phenomenon:

[T]he reduced liquidity is a consequence of higher inventory control costs in the stock of firms with large institutional concentration. This conclusion follows from our finding that there is a positive relation between average transaction size and institutional holdings, suggesting that larger institutional holdings are associated with larger trades, thus forcing the market maker to hold a larger inventory.471

G. Informed Trading and the Market Depth

A related empirical issue is the link between informed trading and the market depth. Steven V. Mann and Robert W. Seijas maintained that the NYSE specialists have more control over the market depth than the spread.472 Similarly, Kenneth A. Kavajecz documented that the NYSE

_______________________________________________________

(continued)

467 Patrick J. Dennis & James P. Weston, Who’s Informed? An Analysis of Stock Ownership and Informed Trading 2-3 (Sept. 25, 2001) (unpublished manuscript, on file with author). 468 Id. at 2. 469 Malay K. Dey & B. Radhakrishna, Institutional Trading, Trading Volume, and Spread 4 (Mar. 2001) (unpublished manuscript, on file with author). 470 Sergey S. Barabanov & Michael J. McNamara, Market Perception of Information Asymmetry: Concentration of Ownership by Different Types of Institutions and Bid-Ask Spread 31 (Sept. 2002) (unpublished manuscript, on file with author). 471 Sarin et al., supra note 459, at 4. 472 Steven V. Mann & Robert W. Seijas, Bid-Ask Spreads, NYSE Specialists, and NASD Dealers, J. PORTFOLIO MGMT., Fall 1991, at 54, 57. One empirical study also argued

2004] INSIDER TRADING AND THE BID-ASK SPREAD 169 specialists “actively manage their quoted depths even when prices are not changing.”473 Some works conclude that informed trading decreases the market depth and similarly attribute this to adverse selection in market making.474 Dominique Dupont even argued that “the depth is more sensitive than the spread to changes in the degree of information asymmetry.”475 Charles M.C. Lee, Belinda Mucklow, and Mark J. Ready examined 230 NYSE firms around earnings announcements and found that “liquidity providers are sensitive to changes in information asymmetry risk and actively manage this risk by using both spreads and depths.”476 Paul Brockman and Dennis Y. Chung linked information-based trading and the market depth on the Stock Exchange of Hong Kong where liquidity is provided by public limit orders.477 Kee H. Chung and Charlie Charoenwong asserted that the market depth is related to the intensity of insiders’ registered transactions as a proxy of information-based trading on the NYSE and AMEX.478 Similarly, Frank Heflin and Kenneth W. Shaw, examining a sample of 303 NYSE firms, concluded that “variation in depths is driven primarily by variation in informed trading, as proxied for by the adverse-selection component, rather than inventory concern . . . the adverse selection component alone explains more than 55 percent of the cross-sectional variation in depth quotes.”479 Yet, an alternative explanation is still possible: “[L]iquidity providers reduce contributed depth prior to an information event in order to reduce adverse selection costs or reduce the costs associated with volatile trading periods.”480

that the “NASDAQ dealers make more frequent revisions in depths than in spreads.” Kee H. Chung & Xin Zhao, Making a Market with Spreads and Depths, 31 J. BUS. FIN. & ACCT. 1069, 1069 (2004). 473 Kenneth A. Kavajecz, A Specialist’s Quoted Depth and the Limit Order Book, 54 J. FIN. 747, 747 (1999). 474 For a literature review on the relation between adverse selection and the market depth, see Frank Heflin & Kenneth W. Shaw, Adverse Selection, Inventory Holding Costs, and Depth, 24 J. FIN. RES. 65, 65-67 (2001). 475 Dominique Dupont, Market Making, Prices, and Quantity Limits, 13 REV. FIN. STUD. 1129, 1130 (2000). One empirical study similarly argued that “new information is reflected overwhelmingly in (bid and ask) depth updates rather than in spread updates.” Sugato Chakravarty et al., Do Bid-Ask Spreads or Bid and Ask Depths Convey New Information First? 23 (Dec. 2001) (unpublished manuscript, on file with author). 476 Lee et al., supra note 113, at 347, 360. 477 Paul Brockman & Dennis Y. Chung, An Analysis of Depth Behavior in an Electronic, Order-Driven Environment, 23 J. BANKING & FIN. 1861, 1883-84 (1999). 478 Charlie Charoenwong & Kee H. Chung, An Empirical Analysis of Quoted Depths of NYSE and Amex Stocks, 14 REV. QUANTITATIVE FIN. & ACCT. 85, 86-87 (2000). 479 Heflin & Shaw, supra note 466, at 80-81. 480 Kavajecz, supra note 473, at 768.

170 CAPITAL UNIVERSITY LAW REVIEW [33:83 H. Regulation Fair Disclosure

Another set of empirical studies considering the adverse selection model pertains to the SEC’s Reg FD that prohibited selective disclosure by the issuer to securities analysts and institutional investors because the practice was said to contribute to information inequality in securities markets and effectively constitute insider trading.481 The following two studies attempted to document lower bid-ask spreads subsequent to Reg FD taking effect, basing their rationale on the adverse selection model.482 Venkat R. Eleswarapu, Rex Thompson, and Kumar Venkataraman looked at a sample consisting of 300 NYSE-listed stocks and found that the post-Reg FD spreads around earnings announcements have decreased by 3.25 basis points.483 Shyam V. Sunder compared the following samples of similar NYSE and NASDAQ firms: 70 companies that placed no restrictions on outsiders to access management’s conference calls with securities analysts and institutional investors before Reg FD and 100 companies that practiced selective disclosure.484 For these two samples, the study found an average bid-ask spread difference of four cents in the pre-Reg FD era485 but no such difference in the post-Reg FD era,486

_______________________________________________________ 481 See ARTHUR LEVITT, TAKE ON THE STREET: HOW TO FIGHT FOR YOUR FINANCIAL

FUTURE 93-111 (rev. ed. 2003) (discussing reasons for adopting Reg FD). “I now believe Reg FD has done more to restore investor confidence in the stock market than any other rule the SEC adopted during my tenure [as the SEC Chairman].” Id. at 95. 482 Some previous empirical research attempted to investigate the interrelationships among the intensity of securities analysts’ following and the adverse selection cost of market making and the likelihood of information-based trading, which might have been related to the practice of selective disclosure. See Michael J. Brennan & Avanidhar Subrahmanyam, Investment Analysis and Price Formation in Securities Markets, 38 J. FIN. ECON. 361 (1995) (asserting that a greater number of analysts following a stock tends to reduce the adverse selection cost); Kee H. Chung et al., Production of Information, Information Asymmetry, and the Bid-Ask Spread: Empirical Evidence from Analysts’ Forecasts, 19 J. BANKING & FIN. 1025 (1995) (arguing that the number of financial analysts is positively related to the extent of information asymmetry, while financial analysts perceive stocks with higher bid-ask spreads to have more profit potential due to private information); David Easley et al., Financial Analysts and Information-Based Trade, 1 J. FIN. MARKETS 175 (1998) (stating that the number of analysts is unrelated to the estimate of information-based trading). 483 Venkat R. Eleswarapu et al., The Impact of Regulation Fair Disclosure: Trading Costs and Information Asymmetry, 39 J. FIN. & QUANTITATIVE ANALYSIS 209, 223 (2004). 484 Shyam V. Sunder, Investor Access to Conference Call Disclosures: Impact of Regulation Fair Disclosure on Information Asymmetry 13 (2002) (unpublished manuscript, on file with author). 485 Id. at 43.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 171 although the average spreads have increased for both groups.487 The study attributed this increase in spreads to a general decline of absolute stock prices and other macroeconomic factors during the post-Reg FD period.488 Both of these studies also found that the overall flow of information has not decreased,489 and one even identified a decrease in volatility around earnings announcements.490 This may mean that the observed change in bid-ask spreads is due to broader dissemination of information and an increase in its quality, leading to decreased volatility—not because of market makers’ losses caused by insider trading.491

H. Critical Studies Despite numerous empirical studies supporting the adverse selection

model,492 critical research has also emerged. One of the first of these studies examined the Securities Acts Amendments of 1964 that extended insider trading and financial disclosure regulation to OTC-traded companies.493 Comparing a sample of 100 industrial companies traded on the OTC market to a sample of 42 national banks traded on national exchanges, it concluded that “increased government regulation of accounting and insider trading did not have any significant effect on the bid / ask spread.”494 Such results mean that “these regulations either did not reduce asymmetric information, or the reduction in asymmetric information had little effect on [the] spread.”495

Robert Neal and Simon M. Wheatley applied two spread decomposition methodologies to a sample of seventeen closed-end mutual 486 Id. at 34. 487 Id. at 29. 488 Id. at 30-31. 489 Eleswarapu et al., supra note 483, at 222; Sunder, supra note 484, at 34. 490 Eleswarapu et al., supra note 483, at 224. 491 This is also consistent with empirical research that found decreased volatility around earnings announcements in the post-Reg FD period. See Frank Heflin et al., Regulation FD and the Financial Information Environment: Early Evidence, 78 ACCT. REV. 1, 34 (2003) (finding “improved information efficiency of stock prices”); Warren Bailey et al., Regulation Fair Disclosure and Earnings Information: Market, Analyst, and Corporate Responses, 58 J. FIN. 2487, 2489 (2003) (arguing that the decrease in volatility is due to the switch to decimal pricing and not to the regulatory changes). 492 See generally Chung & Charoenwong, supra note 442; Eleswarapu et al., supra note 483; Silva & Chavez, supra note 307. 493 Robert L. Hagerman & Joanne P. Healy, The Impact of SEC-Required Disclosure and Insider-Trading Regulations on the Bid / Ask Spreads in the Over-the-Counter Market, 11 J. ACCT. & PUB. POL’Y 233, 234 (1992). 494 Id. at 234, 237. 495 Id. at 242.

172 CAPITAL UNIVERSITY LAW REVIEW [33:83 funds.496 One could have expected the adverse selection component of the bid-ask spread to be low because there are very limited opportunities for informed trading in mutual funds.497 However, this component was found to be 19% and 52%, using these two methodologies.498 Consequently, it was concluded that the models are likely to be misspecified or depend on something other than the insiders’ knowledge about the future liquidation values.499

Another critical study evaluated the empirical work on the adverse selection model by applying some of its variations to a sample of 856 NYSE-traded companies.500 “The major determinant of adverse selection appears to be volatility . . . . An alternative explanation is that inventory costs are higher because of higher volatility, and these costs are reflected in a higher spread.”501 Thus, the adverse selection cost may be confused with _______________________________________________________ 496 Robert Neal & Simon M. Wheatley, Adverse Selection and Bid-Ask Spreads: Evidence from Closed-End Funds, 1 J. FIN. MARKETS 121, 123 (1998) (applying the spread decomposition methodologies from George et al., supra note 334, and Glosten & Harris, supra note 321).

(continued)

497 See Neal & Wheatley, supra note 496, at 143-44. 498 Id. at 138. 499 Id. at 147. 500 Van Ness et al., supra note 238, at 79-83. The study examined the methodologies in the following sources: George et al., supra note 334; Glosten & Harris, supra note 321; Huang & Stoll, supra note 371; Lin et al., supra note 349; Madhavan et al., supra note 377. 501 Van Ness et al., supra note 238, at 77, 95. On the other hand, it is often maintained that insider trading increases the stock price volatility. See, e.g., Julan Du & Shang-Jin Wei, Does Insider Trading Raise Market Volatility?, 114 ECON. J. 916, 917 (2004). One empirical study argued that insiders have the “incentive to choose riskier projects than they otherwise would [and] to manipulate the timing and content of the information release in such a way that will generate more price volatility than otherwise” to maximize their trading profits. Id. The authors based this conclusion on the correlation between insider trading regulation and market-wide volatility. A methodological objection to this conclusion is that additional firm-specific volatility for every firm does not necessarily translate into higher market-wide volatility. Cf. Kahan, supra note 107, at 1027-28. Indeed, there is evidence that a substantial secular increase in firm-specific volatility in the United States had little effect on market-wide volatility. See John Y. Campbell et al., Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk, 56 J. FIN. 1, 40 (2001). But see Christopher T. Stivers, Firm-Level Return Dispersion and the Future Volatility of Aggregate Stock Market Returns, 6 J. FIN. MARKETS 389, 408 (2003) (finding that firm-level stock return dispersion influences the future market-wide volatility in the United States). The reverse causation may also be true: greater volatility may provide better opportunities for insider trading. See Morse & Ushman, supra note 45, at 249. Furthermore, insider trading may even decrease volatility of stock returns by eliminating sudden price jumps. See MANNE, supra note 5, at 80-90, 96-103. Another

2004] INSIDER TRADING AND THE BID-ASK SPREAD 173 the inventory holding cost borne by market makers.502 Indeed, it was admitted earlier that “[i]nventory and adverse information components are difficult to distinguish.”503 The study also concluded that the model used by Huang and Stoll may be superior to others,504 even though it was originally tested on a much smaller sample, and that particular model estimated the adverse selection component as relatively small.505 An attempt to match the indicators of information asymmetry (financial leverage, dispersion of analyst earnings forecasts, book-to-market ratio, R&D expenses and intangibles, and institutional ownership) with the estimates of the adverse selection component was not successful,506 and ultimately, “most of the variables that measure information asymmetries are not related to adverse selection.”507 Furthermore, it was noted that

perspective on this issue suggests that insider trading could induce risk-averse managers to accept riskier (and hence more volatile from the ex ante perspective) projects desirable for risk-neutral shareholders. See RICHARD A. POSNER, ECONOMIC ANALYSIS OF LAW 433-34 (6th ed. 2003); Lucian Arye Bebchuk & Chaim Fershtman, Insider Trading and the Managerial Choice Among Risky Projects, 29 J. FIN. & QUANTITATIVE ANALYSIS 1, 13 (1994). 502 The referenced empirical studies were not consistent in treating the inventory holding component, sometimes lumping it together with the adverse selection or order processing components, or ignoring it altogether. Thus, it is possible that the adverse selection component in fact captures the inventory holding component, especially when the latter cost of market making is excluded from the analysis. 503 Huang & Stoll, supra note 371, at 997. This was pointed out earlier by Henry G. Manne: “[I]nsider trading is more likely in highly risky companies . . . than it is in companies with less variable security prices . . . . So it is possible that what the economists are measuring is the effect of the riskiness of the stock and not insider trading, with which riskiness is highly correlated.” Manne, supra note 95, at 24 n.38. 504 Van Ness et al., supra note 238, at 96. 505 See supra notes 374-76 and accompanying text. 506 Van Ness et al., supra note 238, at 96. 507 Id. at 95. Yet another study found that “the estimates of the adverse selection component of the spread are related to firm characteristics that ex-ante should be associated with the level of information asymmetry.” Jonathan Clarke & Kuldeep Shastri, On Information Asymmetry Metrics 4 (Oct. 3, 2001) (unpublished manuscript, on file with author). The authors noted a “strong relation between the adverse selection component . . . and a measure of [legal] insider trading,” id., as well as a “strong relation” between volatility and the adverse selection component, id. at 27, treating the former as an indicator of information asymmetry, id. at 8. Another study argued that the adverse selection component of the bid-ask spread is correlated with an estimate of the probability of information-based trading. See Kee H. Chung & Mingsheng Li, Adverse-Selection Costs and the Probability of Information-Based Trading, 38 FIN. REV. 257 (2003).

174 CAPITAL UNIVERSITY LAW REVIEW [33:83 “several of the [investigated] models appear to be noisy transformations of the spread.”508

I. Summary Invariably, the theoretical assumptions regarding the causal links

among insider trading, spread, disclosure quality, volatility, and firm size appear to be crucial in guiding empirical work and the interpretations of its results. Thus, the existing empirical studies have to be approached with caution, especially since no empirical consensus has emerged.

XII. CONCLUSIONS A. Widespread Acceptance of the Adverse Selection Argument

Adverse selection literature presents a simple economic model that neither claims to be the exclusive explanation of the existence of the bid-ask spread nor builds a general equilibrium model to assess the overall economic impact of insider trading. Rather surprisingly, the model has been widely accepted as proving a substantial cost of insider trading by economics, finance, and legal academics, and regulators. The model has influenced the work of several Nobel Laureates in economics509 and has

_______________________________________________________ 508 Van Ness et al., supra note 238, at 96. 509 The adverse selection argument was utilized by Robert F. Engle, Merton H. Miller, Franco Modigliani, William F. Sharpe, Myron Scholes, and Vernon L. Smith in their work. “The possibility of heterogeneously informed agents and adverse selection is a well-documented aspect of the uncertainty facing liquidity suppliers.” ROBERT F. ENGLE &

JOE LANGE, MEASURING, FORECASTING AND EXPLAINING TIME VARYING LIQUIDITY IN THE

STOCK MARKET 4 (Dep’t of Econ., Univ. of California, San Diego, Working Paper No. 97-12R, 1997). See also CHO & ENGLE, supra note 274, at 4-5; FRANK J. FABOZZI & FRANCO

MODIGLIANI, CAPITAL MARKETS: INSTITUTIONS AND INSTRUMENTS 118 (3d ed. 2003); SHARPE & ALEXANDER, supra note 91, at 45; Black & Scholes, supra note 145, at 402; Joseph Campbell, Shawn LaMaster, Vernon L. Smith & Mark Van Boening, Off-Floor Trading, Disintegration, and the Bid-Ask Spread in Experimental Markets, 64 J. BUS. 495, 519 (1991); Engle, supra note 210, at 14, 18; Robert F. Engle & Andrew J. Patton, Impacts of Trades in an Error-Correction Model of Quote Prices, 7 J. FIN. MARKETS 1, 2-3, 12-14, 19-22 (2004); Grossman & Miller, supra note 148, at 617, 629; Grossman, Miller, Cone, Fischel & Ross, supra note 107, at 23, 28, 39 & n.23; Miller & Upton, supra note 85, at 156-57.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 175 even surfaced in popular publications such as The Economist,510 Wall Street Journal,511 Fortune,512 and Business Week.513

At the same time, there has been little criticism of this paradigm, even from the school of thought that argued for the deregulation of insider trading, whose representatives, nevertheless, were accused that they “do not understand the economics of market making.”514 The argument for regulating insider trading is often supported by the mere existence of the theoretical model as such, and empirical evidence on adverse selection is frequently cited without questioning its inconsistencies. B. Cost-Benefit Analysis of Insider Trading

The original adverse selection literature did not pass an ultimate judgment on the practice of insider trading. For instance, Lawrence R. Glosten explicitly mentioned that “[t]he increase in efficiency [in pricing due to insider trading] may be worth the concomitant decrease in the liquidity of the market.”515 The adverse selection cost, as well as other costs, must be compared to the benefits of insider trading and the costs of enforcing insider trading regulation. “[A] general equilibrium analysis that considers both the liquidity issues as well as the benefits of insider trading might do much to answer the question of what restraints should be placed on informed trading.”516

The following question is also relevant: is there a detrimental effect on liquidity if corporate insiders and blockholders are excluded from trading on the basis of private information or if selective disclosure by the issuer is _______________________________________________________ 510 See Cheating Is Wrong . . . Isn’t It?, ECONOMIST, May 7, 1988, at 73, 73 (arguing that a higher bid-ask spread as the “insider-dealing tax . . . not only has victims, it is inefficient”). 511 See Robert Bloomfield, Fear of Insiders Dampens Trading, WALL ST. J., May 21, 2001, at A23. 512 See Vinzant, supra note 116, at 258. 513 See Mike McNamee, A Kickback You Can Enjoy, BUS. WK. (Indus./Tech. ed.), Apr. 12, 1999, at http://www.businessweek.com/1999/99_15/b3624142.htm (last visited Jan. 12, 2005). 514 Klock, supra note 107, at 308. 515 Glosten, supra note 92, at 230. 516 Id. See also Peter M. DeMarzo et al., The Optimal Enforcement of Insider Trading Regulations, 106 J. POL. ECON. 602 (1998) (discussing the tradeoff between the loss of liquidity from widened bid-ask spreads and the costs of enforcing insider trading regulation). For more general models of welfare analysis of insider trading, see Antonio E. Bernardo, Contractual Restrictions on Insider Trading: A Welfare Analysis, 18 ECON. THEORY 7 (2001); Sudipto Bhattacharya & Giovanna Nicodano, Insider Trading, Investment, and Liquidity: A Welfare Analysis, 56 J. FIN. 1141 (2001); Hayne E. Leland, Insider Trading: Should It Be Prohibited?, 100 J. POL. ECON. 859 (1992).

176 CAPITAL UNIVERSITY LAW REVIEW [33:83 prohibited? “[I]t is possible that insiders who are trading add more liquidity than they frighten away.”517 Similarly, a prominent economist remarked: “The liquidity of a market is intimately related to the ability of traders to trade on the basis of private information.”518

C. Securities Markets with No Informed Trading? Accepting the adverse selection model may lead to a questionable

conclusion—to minimize the bid-ask spread, only traders with no private information should be in the market. Thus, trading by anyone better informed than a market maker—corporate executives or individuals who possess better analytical capacity for research or private information about the industry or the macroeconomy—would allegedly increase the spread. Yet, if everyone had the same information in the idealized world of “equal access,” there would be fewer incentives to trade, reducing profits from market making.519 _______________________________________________________

(continued)

517 MANNE, supra note 5, at 7-8. 518 Sanford J. Grossman, An Analysis of the Role of “Insider Trading” on Futures Markets, 59 J. BUS. S129, S133 (1986). It should be noted that the existence of a liquid securities market increases the profitability of informed trading. See Ross Levine, Financial Development and Economic Growth: Views and Agenda, 35 J. ECON. LITERATURE 688, 695 (1997). Low transaction costs permit trading on private information that is relatively minor. See Black, supra note 29, at 531; Levine, supra, at 695. Market liquidity also aids trading on time-sensitive information where the immediate availability of a counterparty is important. See Black, supra note 29, at 530-34; Levine, supra, at 695. 519 But even rejecting the desirability of absolute information parity, there is a lengthy debate on whether corporate insiders or market professionals (notably, securities analysts) should be allowed to trade on inside information. One study suggested that the optimal regulatory arrangement should stimulate competition among these two groups. See Jhinyoung Shin, The Optimal Regulation of Insider Trading, 5 J. FIN. INTERMEDIATION 49 (1996). Other scholars proposed that in order to create more liquidity in securities markets and stimulate competition in the acquisition of information, the right to trade on inside information should be given not to corporate insiders but to securities analysts, who are removed from corporate decision-making and enjoy economies of scale and scope in processing information. See Goshen & Parchomovsky, supra note 107, 1251-52. However, competition among corporate insiders, especially in large corporations, not unlike the competition among securities analysts, is also feasible, although there are concerns that it would adversely affect the process of corporate decision-making. Another consideration is whether insiders can provide information at a lower cost than securities analysts, whose efforts are also possibly redundant. “Insiders, in contrast [to market professionals], have less need to make investments in seeking and using information because they hold jobs in which their attention already is directed to that valuable information as a consequence of their duties within their firm.” Haddock & Macey, supra note 10, at 318. For a similar perspective, see Carlton & Fischel, supra note 13, at 880, and Manne, supra note 37, at 573.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 177 It has been pointed out that asymmetric information and heterogeneous

beliefs are positively related to trading volume520 and, consequently, the market makers’ revenues. It follows that asymmetric information, especially if it comes from a variety of sources, both outside and inside the company, and resulting diverging beliefs may actually benefit the providers of liquidity.521 “[T]he relationship between trading volume and the degree of heterogeneity in beliefs and informational asymmetry is both indirect and ambiguous.”522 Similarly, the overall impact of information asymmetry on the bid-ask spread is also ambiguous. Hence, the assertion that market makers “prefer enforcement policies that reduce information asymmetries”523 is not universally true.524 Besides, they may benefit from

Yet, some point to the counterargument that “the same information when gathered by an outsider is more likely to be used in socially more beneficial ways. . . . [S]ociety may be better off if the outsider searches even when he/she is the more expensive searcher than an insider.” Khanna, supra note 19, at 668. Insiders’ trading on inside information may discourage the search for relevant outside information by outsiders and possibly create economic inefficiencies. See Naveen Khanna et al., Insider Trading, Outside Search, and Resource Allocation: Why Firms and Society May Disagree on Insider Trading Restrictions, 7 REV. FIN. STUD. 575, 576 (1994). Another perspective posits that permitting insiders to trade on inside information would likely allow public shareholders to internalize the costs of such activities by reducing managerial salaries by the equivalent of the expected trading profits. See Haddock & Macey, supra note 93, at 1463-64. In the scenario where market professionals trade on inside information, public shareholders still lose, while being unable to recoup their trading losses. Id. However, this conclusion depends on the assumption that the insiders’ unrestricted right to trade on internal information is worth less than their total compensation—the market value of their services to the corporation. See also Easterbrook, supra note 16, at 332 (arguing that insider trading as compensation may be inefficient, as risk-averse managers would value trading profits at a lesser amount than risk-neutral shareholders). 520 Thomas J. George et al., Trading Volume and Transaction Costs in Specialist Markets, 49 J. FIN. 1489, 1490 (1994). See also Goshen & Parchomovsky, supra note 107, at 1251 n.85. 521 Of course, diverging beliefs do not necessarily stem from asymmetric information. See generally Milton Harris & Artur Raviv, Differences of Opinion Make a Horse Race, 6 REV. FIN. STUD. 473 (1993) (offering a theoretical model positing that heterogeneous beliefs about the same information are positively related to the trading volume). See also Hendrik Bessembinder et al., An Empirical Examination of Information, Differences of Opinion, and Trading Activity, 40 J. FIN. ECON. 105 (1996); Paul Brockman & Dennis Y. Chung, An Empirical Investigation of Trading on Asymmetric Information and Heterogeneous Prior Beliefs, 7 J. EMPIRICAL FIN. 417 (2000). 522 George et al., supra note 520, at 1490. 523 Pritchard, supra note 96, at 974.

178 CAPITAL UNIVERSITY LAW REVIEW [33:83 inside information by having access to the order flow data in advance of the rest of the market. D. What Makes the Adverse Selection Argument Valid?

The adverse selection literature has largely ignored the fact that market makers do not passively absorb order imbalances but actively manage their inventory. The real content of the adverse selection argument is that liquidity providers are losing wealth in the process of adjustment to the desired inventory level. But for an actively traded security, such losses are likely to be greatly decreased because market makers can promptly correct deviations from the optimal level. The fact that they trade frequently is more likely to aid providers of liquidity than to harm them.

The question remains whether there are other possible links between insider trading and the bid-ask spread. If insider trading leads to greater stock price volatility (even though the opposite conclusion is also intuitive), then it would increase the market makers’ inventory holding cost and thus increase the spread. Alternatively, if insider trading does deter potential investors from the market in the relevant security, the trading volume will decrease, order mismatches will become more frequent, and the liquidity provider will be forced to increase his preferred level of inventory and face more difficulties in adjusting his actual holdings to the optimal level. Consequently, the market maker’s inventory risk will increase, and his portfolio losses due to insider trading will be more likely. The problem with these alternative links between insider trading and the bid-ask spread is empirical. Overall, insider trading may decrease stock price volatility, and the evidence for the “investor confidence” argument is also uncertain. E. Directions for Further Empirical Research

Once the adverse selection argument is shifted into the realm of public policy, it is crucial to know the magnitude of the social cost, as measured by increased bid-ask spreads. It depends on the following elements: the portion of trades executed by the market maker on his account (which would depend on trading volume, volatility, occurrence of large block trading, etc.); the speed of detecting insider trading activity by liquidity providers; the elasticity of uninformed trading with respect to the spread; the ratio of informed to uninformed trading; competition among insiders 524 It is not suggested that any kind of information asymmetry is unambiguously “good” for a securities market. “Although informed trading is essential for efficient markets, too much informational asymmetry would destroy a market.” Heidle & Huang, supra note 196, at 393. But a market breakdown would happen not because of higher transaction costs, but because of the inability of outside investors to verify the true value of the company with a reasonable degree of accuracy.

2004] INSIDER TRADING AND THE BID-ASK SPREAD 179 and tippees; the flow, quality, and potential price impact of private information; the average time period between the transaction made on private information and the revision of the market price; and the average deviation from the market maker’s optimal inventory caused by insider trading. Knowledge of the behavior of the market makers’ inventories and management techniques is also necessary to assess the cost of insider trading. Little is known to what extent they consider insider trading to be a problem, what measures they use to estimate its occurrence, and how it affects the preferred level of inventory.525

Many empirical studies support the theoretical inferences of the model, but there are some serious doubts about the appropriate interpretation of the data—most notably, a possible confusion of the adverse selection and inventory holding costs. The alleged adverse selection component of the bid-ask spread may capture volatility and not the markup for the market maker’s losses to insiders.

The following directions for future empirical research are suggested: whether more accurate proxies for illegal insider trading, separated from other measurements of information asymmetry, are good predictors of the size of the spread or the market depth; whether the behavior of the market makers’ inventories mitigates losses due to insider trading; and whether liquidity providers derive a net benefit from the presence of informed traders by inferring and profiting on the future price movements. Furthermore, more general questions concerning the relationship between insider trading and liquidity need to be answered: what is the empirical magnitude of the “market integrity”/“investor confidence” argument; what are the liquidity costs of prohibiting trades on private information; and what is the effect of insider trading in derivatives on the liquidity of the market in the underlying stock. F. Overall Implications of the Presented Analysis

A critical analysis of the theory and evidence pertaining to the adverse selection model suggests that the magnitude of the effect of insider trading _______________________________________________________ 525 In fact, market makers are more concerned with the regulatory costs. For instance, when the SEC proposed amendments to Rule 15c2-11 that would require market makers in microcap OTC stocks “to review fundamental information about the issuer and have a reasonable basis for believing that the information is accurate, current, and from reliable sources,” Reproposed Rule: Publication or Submission of Quotations Without Specified Information, Exchange Act Release 41,110, 64 Fed. Reg. 11,124 (Mar. 8, 1999), it was met with strong opposition. “Substantial regulatory costs for market makers will be passed on to investors in the form of wider spreads and less liquidity.” Letter from Walter Carucci, President, Carr Securities, to Jonathan G. Katz, Secretary, Securities and Exchange Commission (Apr. 13, 1999), available at http://www.sec.gov/rules/proposed/s7599/carucci2.htm (last visited Sept. 15, 2004).

180 CAPITAL UNIVERSITY LAW REVIEW [33:83 on the bid-ask spread is rather uncertain. This conclusion is largely based on the observation of the current legal regime in the United States that regulates insider trading, where a substantial amount of both illegal and legal profitable trading by corporate insiders and their tippees is still present. However, an unregulated regime may be more problematic for market makers, even though there is practically no evidence that insider trading caused significant losses for liquidity providers in the United States or other countries before the emergence of the enforced prohibition.

Even in an unregulated environment, financial intermediaries, in their capacity as market makers, may avoid substantial losses to insiders if a liquid securities market allowing for efficient inventory management is retained. They actually could benefit from observing information-motivated trades.

In any instance, stricter enforcement of insider trading laws or further legislative enlargement of their scope is unlikely to bring about a significant reduction in the bid-ask spreads. Of course, this conclusion, by itself, does not warrant deregulating insider trading.