Adverse Selection and Liquidity Distortion in Decentralized Markets

Chang, Briana

doi:10.2139/ssrn.1701997

Cited by 29 publications

(27 citation statements)

References 45 publications

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“…Also, smaller shocks to quality can lead to a market 5 This distinguishes us from Guerreri, Shimer and Wright (2010) that use competitive search to obtain a separating equilibrium in asset markets with adverse selection. Chang (2011) builds on this work to show that liquidity in the form of endogenous market tightness is disturbed downwards in equilibrium when there is a lemons problem for trading assets. Other papers with dynamic adverse selection also arrive at a pooling equilibrium, but by requiring that transactions have to take place at a single price (see for example Eisfeldt, 2004;Kurlat, 2010).…”

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confidence: 99%

Trading Dynamics with Adverse Selection and Search: Market Freeze, Intervention and Recovery

Chiu

Koeppl

2011

SSRN Journal

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We study the trading dynamics in an asset market where the quality of assets is private information of the owner and finding a counterparty takes time. When trading of a financial asset ceases in equilibrium as a response to an adverse shock to asset quality, a large player can resurrect the market by buying up lemons which involves assuming financial losses. The equilibrium response to such a policy is intricate as it creates an announcement effect: a mere announcement of intervening at a later point in time can cause markets to function again. This effect leads to a gradual recovery in trading volume, with asset prices converging non-monotonically to their normal values. The optimal policy is to intervene immediately with minimal size when markets are deemed important and losses are small. As losses increase and the importance of the market declines, the optimal intervention is delayed and it can be desirable to rely more on the announcement effect by increasing the size of the intervention. Search frictions are important for all these results. They compound adverse selection, making a market more fragile with respect to a classic lemons problem. They dampen the announcement effect and cause the optimal policy to be more aggressive, leading to an earlier intervention at a larger scale. JEL classification: G1, E6 Bank classification: Financial markets; Financial stability RésuméLes auteurs étudient la dynamique des échanges sur un marché où la qualité des actifs est une information privée détenue par les propriétaires et où la recherche d'une contrepartie demande du temps. Lorsque, à l'équilibre, les actifs financiers ne sont plus échangés par suite d'un choc entraînant une dégradation de leur qualité, l'intervention d'un participant de grande stature, qui est prêt à acheter des actifs de mauvaise qualité et, donc, à supporter des pertes financières, peut relancer les échanges. Cette intervention donne lieu à un équilibre complexe car elle produit un effet d'annonce : le seul fait d'annoncer une intervention à venir peut amener les marchés à fonctionner de nouveau. Cet effet entraîne une reprise graduelle du volume d'échanges, les prix convergeant de façon non monotone à leurs valeurs normales. La politique optimale consiste à intervenir immédiatement par l'acquisition d'un volume minimal d'actifs pendant que le marché est jugé important et que les pertes sont minces. Lorsque les pertes grossissent et que l'importance du marché décline, il devient optimal d'intervenir plus tardivement, et il peut alors être préférable de compter davantage sur l'effet d'annonce en haussant la taille des achats escomptés. Les frictions concernant la prospection comptent dans tous ces résultats. Elles amplifient l'antisélection, rendant le marché plus vulnérable aux difficultés que crée généralement la présence d'actifs de piètre qualité. Elles atténuent l'effet d'annonce et requièrent une politique optimale plus ambitieuse, c'est-à-dire une intervention précoce à plus grande échelle.

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Trading Dynamics with Adverse Selection and Search: Market Freeze, Intervention and Recovery

Chiu

Koeppl

2011

SSRN Journal

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“…The general finding of this research is that, unlike in the classic Akerlof (1970) model, trade does not necessarily break down. Owners of higher quality assets can signal the quality by accepting either a lower probability of trade (Chang (2011), Guerrieri and Shimer (2014)) or longer waiting times (Daley and Green (2012), Fuchs and Skrzypacz (2014)) in return for higher prices. While the possibility to signal higher asset quality allows for all assets to be eventually traded, trade is inefficiently delayed.…”

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confidence: 99%

Dynamic Adverse Selection: Time-Varying Market Conditions and Endogenous Entry

Zryumov

2015

SSRN Journal

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In this paper I analyze the effects of time-varying market conditions and endogenous entry on the equilibrium dynamics of markets plagued by adverse selection. I show that variation in gains from trade, stemming from market conditions, creates an option value and distorts liquidity when gains from trade are low. An improvement in market conditions triggers a wave of high-quality deals due to the preceding illiquidity and lack of incentives to signal quality. When gains from trade are high, the market is fully liquid; high prices and no delay in trade attract low-grade assets, and the average quality deteriorates. My analysis also reveals that illiquidity can act as a remedy as well as a cause of inefficiency: partial illiquidity allows for screening of assets and restores efficient entry incentives. I demonstrate model implications using several applications: early stage financing, initial public offerings, and private equity buyouts. Disciplines Finance and Financial ManagementThis working paper is available at ScholarlyCommons: http://repository.upenn.edu/fnce_papers/24Electronic copy available at: http://ssrn.com/abstract=2653129 conditions triggers a wave of high-quality deals due to the preceding illiquidity and lack of incentives to signal quality. When gains from trade are high, the market is fully liquid; high prices and no delay in trade attract low-grade assets, and the average quality deteriorates. My analysis also reveals that illiquidity can act as a remedy as well as a cause of inefficiency: partial illiquidity allows for screening of assets and restores efficient entry incentives. I demonstrate model implications using several applications:early stage financing, initial public offerings, and private equity buyouts. * I thank my advisors Andrzej Skrzypacz and Ilya Strebulaev for numerous lengthy discussions, valuable feedback, continuous support, and encouragement. I would also like to thank Peter DeMarzo, Steven Grenadier, and participants in the Stanford GSB Research Seminar for many constructive comments.†

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“…7 Guerrieri et al (2010) and Chang (2011) study the adverse selection problem where the types are exogenously given and principals post offers to screen different types. In contrast to these papers, here the types are endogenously determined, which leads to a moral hazard problem.…”

Section: Introductionmentioning

confidence: 99%

“…The restriction on beliefs proposed here is similar to Guerrieri et al (2010), which is later formalized by Chang (2011). When a seller considers posting a deviating offer (q, d) / ∈ Ω, the seller expects to attract the type of buyer who is most likely to come; that is, the type of buyer who is willing to visit at the lowest matching probability.…”

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The threat of counterfeiting in competitive search equilibrium

Shao

2014

Journal of Economic Dynamics and Control

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Recent studies in monetary theory show that if buyers can use lotteries to signal the quality of bank notes, counterfeiting does not occur in a pooling equilibrium. In this paper, I investigate the robustness of this non-existence result by considering an alternative trading mechanism. Specifically, a competitive search environment is employed in which sellers post offers and buyers direct their search based on those offers. In contrast to the previous studies, buyers' ability to signal is fully eliminated in this environment. However, I find that counterfeiting does not exist if the equilibrium concept proposed by Guerrieri et al. (2010) is used. This is a refinement scheme in which sellers' out-of-equilibrium beliefs about the likelihood of meeting with different types of buyers are restricted. Moreover, a threat of counterfeiting can result in the collapse of a monetary equilibrium. An extension of the model is provided which allows the threat of counterfeiting to materialize, in that some buyers cannot observe the offers, and therefore search randomly. Counterfeit notes are produced by those buyers who randomly search. JEL classification: D82, D83, E42 Bank classification: Bank notes RésuméLes récentes études en théorie monétaire ont montré que, si les indications des acheteurs sur la qualité des billets de banque sont obtenues au moyen de loteries, la contrefaçon n'existe pas en situation d'équilibre non séparateur. L'auteur fait appel ici à un autre mécanisme de négociation pour vérifier la robustesse de ce résultat. Il définit un cadre de prospection concurrentielle dans lequel les vendeurs affichent des offres qui aiguillent les acheteurs. Il est impossible à ces derniers de transmettre des signaux, hypothèse différente de celle retenue dans les travaux précédents. L'auteur conclut que, malgré cela, la contrefaçon n'existe pas en situation d'équilibre si l'équilibre est défini à la manière de Guerrieri et autres (2010), qui appliquent des restrictions aux croyances hors équilibre des vendeurs quant à la probabilité de rencontrer différents types d'acheteurs. L'étude fait en outre ressortir qu'une menace de contrefaçon peut entraîner l'effondrement de l'équilibre monétaire. L'auteur présente une extension du modèle dans laquelle cette menace peut se concrétiser du fait que certains acheteurs n'ont pas connaissance des offres et procèdent par conséquent à la prospection de manière aléatoire. Ce sont ces acheteurs qui peuvent produire de faux billets.

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Adverse Selection and Liquidity Distortion in Decentralized Markets

Cited by 29 publications

References 45 publications

Trading Dynamics with Adverse Selection and Search: Market Freeze, Intervention and Recovery

Trading Dynamics with Adverse Selection and Search: Market Freeze, Intervention and Recovery

Dynamic Adverse Selection: Time-Varying Market Conditions and Endogenous Entry

The threat of counterfeiting in competitive search equilibrium

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