Disclosure Quality and Market Liquidity : Impact of Depth Quotes and Order Sizes

We study the relation between disclosure policy and market liquidity. Our tests examine how two key aspects of market liquidity, the effective bid-ask spread and quoted depth, relate to financial analysts' ratings of firms' disclosure policies. We introduce a method of combining order sizes and depth quotes to yield more precise estimates of effective spreads on trades likely constrained by quoted depth. We find that while firms with higher rated disclosures are charged lower effective spreads, they are also quoted lower depth, consistent with the notion that better disclosures reduce information asymmetry but cause some liquidity suppliers to exit the market (e.g. Diamond and Verrecchia 1991). Thus, a simple examination of spreads and depths yields ambiguous inferences on the relation between disclosure policy and market liquidity. We resolve this ambiguity by estimating depth-adjusted effective spreads, and find that firms with higher rated disclosures have lower depth-adjusted effective spreads across all trade sizes. Overall, our results suggest a robust inverse relation between disclosure ratings and effective trading costs. Thus, a policy of enhanced financial disclosure is related to improved market liquidity