Information Disclosure and Market Quality: The Effect of SEC Rule 605 on Trading Costs Xin Zhao and Kee H. Chung

Recent changes in disclosure rule  Regulation Fair Disclosure (Reg FD) – October 2000  NYSE’s OpenBook – September 28, 2001  NASDAQ’s SuperMontage – October 11, 2002  SEC Rule 605 – May 1, 2001  SEC Rule 606 – January 30, 2001

Regulation Fair Disclosure  Mandated that all publicly traded companies must disclose material information to all investors at the same time.  The regulation sought to stamp out selective disclosure. selective disclosure  Regulation FD changed fundamentally how companies communicate with investors, by bringing better transparency and more frequent and timely communications, perhaps more than any other regulation in the history of the SEC.transparency

NYSE’s OpenBook  NYSE OpenBook provides a real-time view of the Exchange's limit-order book for all NYSE-traded securities.  Traders see aggregate limit-order volume at every bid and offer, thus raising the NYSE market to an even greater level of transparency.  NYSE OpenBook is available via an electronic data feed or via market data vendor services.

NASDAQ’s SuperMontage  The SuperMontage is NASDAQ's trading system to aggregate quotes and orders, providing access to more possible trades.  The key features include pre-trade anonymity, the ability to aggregate interest five price levels deep on each side of the market.  A high level of confidence of best execution for users.

SEC Rule 605 and 606  Increase the visibility of execution quality of the U.S. securities markets for public investors.  Market centers that execute investor orders are required to make monthly disclosures of information on execution quality. Present study  Broker-dealers will be required to disclose the identity of the market centers to which they route orders on behalf of customers.

Our findings on Rule 605  The effective and quoted spreads declined significantly.  The decline cannot be attributed to a trend in spreads, concurrent changes in stock attributes, or decimal pricing.  Although the quoted depth of NYSE stocks also declined, overall market quality is higher after implementation of the Rule.  The SEC ’ s goal to improve execution quality through more transparent markets has been achieved.

What is Rule 605?  The SEC adopted Rule 605 on November 15,  The Rule requires market centers to make monthly public disclosure of execution quality.  The Rule is intended to achieve a more competitive and efficient national market system by increasing the visibility of execution quality.

 To facilitate comparison across market centers, the Rule adopts basic measures of execution quality.  For each security, the statistical information is categorized by five types of orders and four order size groups.  For market orders and marketable limit orders, the Rule requires market centers to report effective spreads and price improvement rates.  The Rule requires all market centers to post monthly order-execution reports on their websites.

What are market centers?  The term "market center" is defined as "any exchange market maker, OTC market maker, alternative trading system, national securities exchange, or national securities association. “  Market centers that trade NMS securities are required to make monthly electronic disclosures of information regarding execution quality on a stock-by-stock basis.

Prior studies  Boehmer (2005) performs a post-decimal comparison of market quality between NYSE and NASDAQ securities.  He, Odders-White, and Ready (2005) compare effective and realized spreads for marketable orders in NYSE-listed and NASDAQ stocks.  Boehmer, Jennings, and Wei (2005) investigate whether brokers and traders use Rule 605 data in order-routing decisions.  Lipson (2004) examines competition among six market centers for NYSE-listed stocks using Rule 605 data.

 Boehmer, Saar, and Yu (2005) examine the effect of pre-trade transparency on market quality by analyzing the NYSE's OpenBook service.  Bessembinder, Maxwell, Venkataraman (2006) analyze the effect of post-trade transparency on market quality in corporate bond markets.

Research design  Market centers have an incentive to improve their execution quality for month t, although it will be available by the end of month t + 1.  We assume that market centers ’ adjustment to the Rule would be completed by the end of month t + 1.  We define months t and t + 1 as the event period, months t – 2 and t – 1 as the pre- rule period, and months t + 2, t + 3, …, t + N as the post-rule period, where N is set large enough to capture the full effect of the Rule.

NYSE and AMEX samples  For the 1,000 most active NYSE securities and 200 most active AMEX securities, we consider March and April 2001 as the pre- rule period.  To measure the short- and long-term effects, we consider the following two post-rule periods: July and August 2001 (Post S ) and July, August, October, November, and December 2001 (Post L )

NASDAQ sample  We consider July and August 2001 as the pre-rule period.  Two post-rule periods: December 2001 and January 2002 (Post S ) and December 2001 through March 2002 (Post L ).  We do not include September 2001 in the post-rule period for NYSE securities and in the pre-rule period for NASDAQ securities because of the September 11, 2001 attack.

Market quality measures

Conclusions  The average effective and quoted spreads of NYSE stocks declined by more than 20%.  Although the average quoted depth of NYSE stocks also declined, the post-rule market quality is better than the pre-rule market quality.  For the AMEX study sample, the effective and quoted dollar spreads declined by more than 20% while the quoted depth increased by more than 20%. We find significant reductions in NASDAQ spreads as well.  We conclude that the SEC ’ s goal to improve execution quality through more transparent markets has been achieved.