The Relationship between Insider Trading and the Bid-Ask Spread: A Critical Evaluation of the 'Adverse Selection' Model

Abstract

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.