Did Reg FD Have Unintended Consequences?

Heidi Moore has an interesting interview with Vanderbilt professor Robert Whaley, who claims to have found some nasty unintended consequences to the SEC’s Regulation Fair Disclosure, which tried to ensure investors were on a level playing field with respect to getting information from listed companies.

Here’s how Whaley explains it to Moore:

We looked at the behavior of bid-ask quotes. What we found is that the cost of trading with informed traders had actually gone up. The market maker has to charge this premium because he may be trading with someone that’s better informed than he is. The material information about a company is known by a handful of people who are now in a better position to trade on it and the rest of the market doesn’t know. The market maker has to protect himself against those people…

What surprised me was that the magnitude of the insurance-cost component of the trading went up 36% for a pretty large sample of firms.

It’s one of those cute and counterintuitive results which economists love, especially if they have a libertarian bent and are suspicious of government regulation. But if you look at the paper, it turns out that market-makers’ bid-ask quotes actually narrowed after Reg FD was implemented, from 13.23 cents per share to 11.43 cents per share.

Whaley’s contention is that the component of that bid-ask spread attributable to "adverse selection" costs rose by 36% — from 0.88 cents per share to 1.20 cents per share. Here’s how his paper puts it:

The adverse selection component rose from

about 6.6 percent to about 10.5 percent of the volume-weighted effective spread. In dollar terms,

this increase amounts to .0663x$.1323

or $.0088 per share pre-Regulation FD, and


or $.0120 post–an increase of 36 percent. We conclude that Regulation FD had

an economically significant chilling effect.

An "economically significant chilling effect"? Bid-ask spreads came down, remember, and even if you sign on to Whaley’s math, the bit of the bid-ask spread that he’s worried about rose by less than one-third of one cent per share. I’m surprised that’s even statistically significant, let alone a "chilling effect".

No wonder, then, that Whaley says reaction to his paper has been "kind of muted". But "I’m out there advocating," he says — maybe if he does a few more interviews with WSJ reporters, he might be able to get a reaction from people who haven’t bothered to read his paper.

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