Dolgopolov 2004 On Bid-Ask Spread

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
_______________________________________________________
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
(continued)
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
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
(continued)
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).
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).
19 20
outsiders, provoke conflicts among groups of shareholders, 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
(continued)
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
(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
(continued)
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.
32
some “adverse” transactions. 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
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
(continued)
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”).
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).
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
_______________________________________________________
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
(continued)
48
BAGEHOT 1971
• 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).
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.
• “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.
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).
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
_______________________________________________________
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
(continued)
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).
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).
99
the firm’s cost of capital, and its stock price. 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
_______________________________________________________
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
(continued)
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).
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
_______________________________________________________
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
(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
(continued)
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
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
(continued)
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
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
(continued)
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.
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
_______________________________________________________
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
(continued)
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.
121
shares’ liquidity, 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”).
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
_______________________________________________________
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
(continued)
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).
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).
146
position. 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
_______________________________________________________
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
(continued)
155 156
inventory risk sharing on the London Stock Exchange (LSE). 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”).
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
_______________________________________________________
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
(continued)
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).
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).
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).
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
_______________________________________________________
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
(continued)
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,
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
(continued)
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
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
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.

201
the adverse selection model. 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
_______________________________________________________
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
(continued)
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).
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.
211
information . . . before it becomes public.” 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).
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
_______________________________________________________
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
(continued)
221
as investment banks for the issuer, 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.
226
market.” 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.
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).
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).
240
macroeconomic news.” 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
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).
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
_______________________________________________________
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
(continued)
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.
261
be economically insignificant.” 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”).
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
_______________________________________________________
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
(continued)
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”).
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.
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,
_______________________________________________________
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
(continued)
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).
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
_______________________________________________________
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
(continued)
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.
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).
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
_______________________________________________________
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”
(continued)
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.
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).
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).
318 319
investors is negatively related to the bid-ask spread. 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.
• 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.
333
• The “adverse-selection” component was estimated at 2%.
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.
• 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
• 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.
• 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.
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.
371
HUANG AND STOLL 1997
• 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
• 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.
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.
• 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
• 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.
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 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.
• 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
• 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.
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
• 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.
431
HANOUSEK AND PODPIERA 2003
• 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
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
(continued)
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
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
(continued)
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).
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.
453
insider trading and spreads. 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
_______________________________________________________
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
(continued)
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).
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
_______________________________________________________
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
(continued)
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.
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.
487
although the average spreads have increased for both groups. 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.
496
funds. 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).
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
(continued)
502
the inventory holding cost borne by market makers. 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
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).
“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
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.
510
even surfaced in popular publications such as The Economist, 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).
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
_______________________________________________________
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.
(continued)
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.
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.
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).
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.

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INSIDER TRADING AND THE BID-ASK SPREAD: A

CRITICAL EVALUATION OF ADVERSE SELECTION IN

In economic, finance, and legal literature, there is a widespread acceptance of

II. DEVELOPMENT OF THE ADVERSE SELECTION MODEL

An interesting issue arises when the insider deals with a

B. Subsequent Early Research

Subsequent theoretical research further analyzed the losses of market

• The market maker has “to provide liquidity by stepping in and

• The market maker always loses to informed traders, who “are

• Depending on the elasticity of uninformed trading to the size

• The spread depends on “the average rate of flow of new

• The market maker (“jobber”) interacts with speculators who

• The market maker possesses only public information, has no

• The market maker “has to recognize any loss he has made

• Setting a higher bid-ask spread would decrease the

• “The immediate burden of paying the speculator his winnings

• The jobber may “revise his central price when an

• The spread is determined by “the total transaction frequency,”

COPELAND AND GALAI 198361

• The market maker deals with two types of traders: “those

• The determination of the bid-ask spread is “a tradeoff between

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

• If the marker maker is a monopolist, he will set the spread that

• The spread is determined by the probability of informed

GLOSTEN AND MILGROM 198568

• “The problem of matching buyers with sellers” is examined in

• The “risk-neutral competitive specialist” recoups the losses

• “[A] bid-ask spread can be a purely informational

• “[T]he value expectations of the specialist and the insiders

• In some circumstances, the market would shut down because

• The problem of market breakdowns can be resolved by

• The specialist updates his expectations about the security’s

• The bid-ask spread depends on the quality of inside

• The adverse selection model may explain “the small firm

• Three types of transactors are present: “a single insider who

• Market makers cannot distinguish between traders, and “the

• Due to insiders’ transactions, their “private information is

• The market makers earn zero economic profits;82

• Insider trading adversely affects market liquidity through a

• The model is “a rigorous version of the intuitive story told by

D. Further Implications of the Model

The essence of the adverse selection model is that because of order

III. ACCEPTANCE AND USE OF THE ADVERSE SELECTION ARGUMENT

IV. INVENTORY AND LOSSES TO MARKET MAKERS

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

V. COMPARATIVE MARKET MAKING AND INFORMED TRADING

A. Alternative Trading Mechanisms

B. Features of the Specialist System

Unlike specialists, competing dealers are unwilling to experiment at

Leach & Madhavan, supra note 91, at 377.

VI. WIDENING SPREADS OR PRICE DISCOVERY?

VIII. CREAM-SKIMMING AND PAYMENT FOR ORDER FLOW

Chairman and then-member of the National Association of Securities Dealers Board of

IX. INFORMED TRADING AND MARKET MAKING IN DERIVATIVE

C. Option Listings and the Liquidity of the Underlying Stock

X. OVERALL MARKET LIQUIDITY AND INSIDER TRADING

XI. EMPIRICAL EVIDENCE ON THE LINK BETWEEN INSIDER TRADING

• A sample of 20 NYSE stocks is used;322

• With price discreteness ignored, the adverse selection

• Samples of NASDAQ stocks (varying from 765 to 821 stocks)

• The spread is decomposed into the order processing, inventory

• The adverse information component is estimated at 43%, the