Securities Regulation, Economics Of

Disclosure Obligations

Imposing a disclosure obligation on corporations that issue securities to the investing public was among the earliest regulatory measures regarding securities. Economic analysis of the statistical effect of the disclosure obligation on securities' prices and their volatility came early and continues with increasing sophistication. Generally, the disclosure obligation or its expansion produces higher prices and reduced volatility. The consistently significant effect of disclosure obligations has been the improvement of market liquidity via the reduction of the bid-ask spread (that is, the difference between the higher price at which market makers stand ready to sell, known as ask, and the lower price at which they stand ready to buy, known as bid). Other aspects of market liquidity, such as the impact of trades on prices, the speed of execution of large orders, and the number of shares offered at the bid or ask (known as depth), have not been studied as much.

The theoretical analysis of disclosure rules follows a meandering path. While the pragmatic reaction to such rules was welcoming, an answer rooted in free-market intuitions soon developed. If disclosure were desirable, then private initiative should provide it. One of the more powerful arguments in this vein is a signaling one. With no disclosure, investors value all firms equivalently. This produces an incentive on the best firms to distinguish themselves and obtain a higher valuation. Although they receive that benefit, investors still treat all remaining firms alike. This produces the same incentive on the next-best firms, and so on, until only the worst firms remain silent.

A more sophisticated version of this argument acknowledges that some information cannot be credibly communicated to investors, notably, managerial skill. Disclosure may not help investors to ascertain managerial skill because poor managers may have been lucky and still have good news to announce or able managers may have been unlucky and have bad news to announce. In this setting, a better signaling equilibrium may be called humble disclosure, the hypothesis being that investors expect able managers not to announce good news and to announce bad news. Poor managers cannot afford this humble stance and sit on bad news and announce good news because they are not likely to obtain good news again.

Even if investors held this signaling belief of humble disclosure, it may not argue against mandated disclosure. The signaling scheme requires latitude only about the timing of announcements, and the current regime of quarterly performance reports may leave enough latitude for early announcements. Moreover, the disclosure system ensures the eventual release of information that serves to reveal the type of management.

The emergence of the market microstructure literature added to the disclosure debate by acknowledging the possible survival of destabilizing trading that is not based on principled analysis of information, labeled irrational or “noise” trading (the conventional analysis held that such trading practices would not survive).

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