This study examines the differential impact of illegal insider trading on liquidity in the alternative market structures of the NYSE (specialist), NASDAQ (dealer), and the CBOE (hybrid). Using US Securities and Exchange Commission (SEC) prosecuted insider trades, we investigate changes in bid ask spread measures. This study contributes to, and extends, the literature on insider trading in several ways. Firstly, by specifically examining SEC prosecuted insider trading cases, this thesis utilises a direct measure of informed trading and adverse selection risk. Secondly, literature in the field has mainly focused on event studies. This is the first study to examine the impact of illegal insider trading on liquidity in a cross-sectional framework. Thirdly, it is also the first study to examine the impact of illegal insider trading on the liquidity of option contracts, in addition to investigating the relationship between informed trading in the options and underlying stock of a company. Finally, since the identification of informed traders by market makers is dependent on the implicit trader anonymity built in to the alternative market structures, this study also contributes to literature on trader anonymity, by examining the level of trader anonymity - the extent to which a trader is recognized as informed – afforded to illegal insider traders on each market.
Results indicate that bid ask spreads are greater on the NYSE on insider trading days, but narrower or unchanged on NASDAQ, which suggests that the specialist system offers less trader anonymity than the competitive dealer system. However, our cross-sectional regressions reveal that it is the trade characteristics of the informed trades which possibly signal the presence of informed traders to market makers. In addition we also find that paired option trades of NASDAQ underlying stocks experience an improvement in liquidity, while NYSE underlying stock options experience no significant change. These findings suggest that the hybrid market structure is in fact fragmented like the NASDAQ dealer system and offers greater trader anonymity than the NYSE specialist system. Furthermore, we find that the main determinant of option spreads is the quoted spreads of the underlying stocks, which lend further support to Cho and Engle’s (1998) derivative hedge theory.