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.
The issue of insider trading1 has never disappeared from academic and public policy debates during the past four decades,2 and this practice hasPage 84 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
Academic analysis has considered insider trading from the perspectives of such diverse5 disciplines as economics, 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
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 byPage 87 outsiders,19 provoke conflicts among groups of shareholders,20 and increase the corporate cost of capital.21
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
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 -therebyPage 89 increasing the costs of transacting. The importance of the spread is that it represents the "price for immediacy"27 and the "cost of trading and the illiquidity of a market."28
The adverse selection model analyzes interaction of a market maker with informed and uninformed traders.29 Because providers of liquidity, unable to distinguish among types of traders, are always "losing" on trades with better-informed counterparties,30 they must charge everyone a higher bid-ask spread to compensate for their losses31 and still enter intoPage 90 some "adverse" transactions.32 Furthermore, insider trading is said to impose a social loss: securities prices are discounted due to higher transaction costs,33 and some potential investors refrain from participating in such markets.34
Thus, the case for regulating insider trading was alleged: "[Informed] trades can damage the dealer, perhaps fatally. That's a valid reason for discouraging trading on so-called 'inside' information, quite apart from whether such trading entails misappropriation of corporate property or wire fraud."35 Similarly, a leading legal academic has remarked that "the more that the law successfully prohibits the use of non-public information, the more that the market maker can (and will be forced by competitive pressure to) narrow the bid-ask spread."36
The adverse selection argument is not concerned with the "unfairness" of trading on inside information or with wealth transfers from uninformed to informed traders.37 Rather, it points out an economic cost of insiderPage 91 trading: a higher bid-ask spread and a corresponding decrease in market liquidity. A wealth of empirical evidence is cited in support of this theory. Yet the model does not attempt to describe a general equilibrium in securities markets. Indeed, the argument is quite elegant and simplified, as one would justly expect from an economic model.
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" andPage 92 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...