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Adverse Selection and Liquidity Distortion in Decentralized Markets

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  • Briana Chang

    (Northwestern University)

Abstract

This paper develops a theory of market illiquidity driven by adverse selection in decentralized markets, in which traders care about both the trading price and how fast they can find a counterparty. The model captures two key notions of illiquidity, market thinness and price undervaluation, and demonstrates how each arises endogenously. When illiquidity manifests itself as market thinness, sellers face long delays in finding a buyer. In certain cases, illiquidity also generates a price discount. In particular, sellers who are relatively distressed financially choose to transact quickly, but accept a price below the fundamental value. The model rationalizes limited market participation, it accounts for fire sales, and it explains how trading volume dries up when dispersion in quality increases. The paper also provides conditions under which each type of liquidity distortion occurs and therefore separately identifies the effects of adverse selection on trading price as well as trading volume.

Suggested Citation

  • Briana Chang, 2012. "Adverse Selection and Liquidity Distortion in Decentralized Markets," 2012 Meeting Papers 403, Society for Economic Dynamics.
    • Handle: RePEc:red:sed012:403
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    References listed on IDEAS

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    Cited by:

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    2. Benjamin Lester & Guillaume Rocheteau & Pierre‐Olivier Weill, 2015. "Competing for Order Flow in OTC Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 47(S2), pages 77-126, June.
    3. Gehrig, Thomas & Fohlin, Caroline & Haas, Marlene, 2015. "Rumors and Runs in Opaque Markets: Evidence from the Panic of 1907," CEPR Discussion Papers 10497, C.E.P.R. Discussion Papers.
    4. William Fuchs & Andrzej Skrzypacz, 2019. "Costs and benefits of dynamic trading in a lemons market," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 33, pages 105-127, July.
    5. Chen, Sonja, 2016. "Adverse selection in the labour market and the demand for vocational education," CLEF Working Paper Series 3, Canadian Labour Economics Forum (CLEF), University of Waterloo.
    6. Andrew Atkeson & Andrea L. Eisfeldt & Pierre-Olivier Weill, 2013. "The market for OTC derivatives," Staff Report 479, Federal Reserve Bank of Minneapolis.
    7. Fernández-Blanco, Javier & Preugschat, Edgar, 2018. "On the effects of ranking by unemployment duration," European Economic Review, Elsevier, vol. 104(C), pages 92-110.

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