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Adverse Selection and Liquidity Distortion in Decentralized Markets

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  • Briana Chang

    (Northwestern University)

Abstract

This paper studies the competitive equilibrium outcome in decentralized asset markets when both search friction and adverse selection play roles. In a dynamic environment with heterogeneous sellers and buyers, I show how adverse selection leads to the downward distortion of equilibrium market liquidity. The model predicts a strong link between the market liquidity and the underlying uncertainty stemming from adverse selection and therefore provides an explanation for the existence of massive illiquidity. As our setup captures two important dimensions in the trading market, price and liquidity, it shows how price and liquidity are jointly determined as an equilibrium outcome and further sheds lights on market segmentation. The framework also allows for a richer analysis of how sorting pattern is determined in such an environment and how different market segmentation may arise when sellers' motives for sale are unknown to the market.

Suggested Citation

  • Briana Chang, 2011. "Adverse Selection and Liquidity Distortion in Decentralized Markets," 2011 Meeting Papers 157, Society for Economic Dynamics.
    • Handle: RePEc:red:sed011:157
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    References listed on IDEAS

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    Cited by:

    1. Veronica Guerrieri & Robert Shimer, 2014. "Dynamic Adverse Selection: A Theory of Illiquidity, Fire Sales, and Flight to Quality," American Economic Review, American Economic Association, vol. 104(7), pages 1875-1908, July.
    2. Shao, Enchuan, 2014. "The threat of counterfeiting in competitive search equilibrium," Journal of Economic Dynamics and Control, Elsevier, vol. 47(C), pages 168-185.
    3. Andrew Atkeson & Andrea L. Eisfeldt & Pierre-Olivier Weill, 2013. "The market for OTC derivatives," Staff Report 479, Federal Reserve Bank of Minneapolis.
    4. Michael J. Fishman & Jonathan A. Parker, 2015. "Valuation, Adverse Selection, and Market Collapses," The Review of Financial Studies, Society for Financial Studies, vol. 28(9), pages 2575-2607.
    5. Halket, Jonathan R & Pignatti, Matteo, 2012. "Housing tenure choices with private information," Economics Discussion Papers 8961, University of Essex, Department of Economics.
    6. Zhang, Shengxing, 2018. "Liquidity misallocation in an over-the-counter market," Journal of Economic Theory, Elsevier, vol. 174(C), pages 16-56.
    7. repec:esx:essedp:717 is not listed on IDEAS
    8. Halket, Jonathan & Pignatti Morano di Custoza, Matteo, 2015. "Homeownership and the scarcity of rentals," Journal of Monetary Economics, Elsevier, vol. 76(C), pages 107-123.

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