Stock Market Liquidity and Optimal Management Compensation: Theory and Evidence

Recent research strongly suggests that CEO incentive schemes are not solely determined by the standard considerations of risk-sharing and effort. Here, we examine the effect of the microstructure of the market in which the firm's shares are traded. If informed traders are free to choose both the size of orders they place on the market and the amount of information they gather, an increase in market liquidity makes the stock price more informative and increases the optimal linkage between CEO compensation and shareholder wealth. If on the other hand informed traders are severely restricted in their ability to take positions by considerations such as wealth constraints, increased liquidity reduces the informativeness of share price and dilutes optimal CEO incentives. We find evidence to support the second view in a sample of 329 large US corporations. There is a positive relationship between a CEO's observed pay-for-performance and the bid-ask spread that prevails in the market for the firm's shares, even after controlling for firm size and riskiness. The relationship is weaker for CEO incentives due to their stockholdings. This suggests that the positive observed relationship between incentives and the spread is not due to simple reverse causality whereby higher insider stockholdings increases informed trading and increases the spread. Our sample contains firms that are listed on either the NYSE or the NASD. The relationship between CEO incentives and the spread is significant and positive only for the NYSE firms, and NYSE firms have significantiy higher pay-performance sensitivities. We also find for our sample that, controlling for firm size, volatility is higher for NASD firms with a smaller bid-ask spread. These results suggest a regulatory explanation whereby the monopoly specialist on the NYSE widens the bid-ask spread on small trades and subsidises on more informative large trades because of an affirmative duty to dampen large price movements. This makes NYSE stock prices more informative, especially when the observed spread is wide.