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

Abstract

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.

Competing mechanisms in markets for lemons

“…28 This is true since, as shown, sellers with a high-quality good trade with a lower probability than sellers with a low-quality good. 29 See Manelli and Vincent (1995) for the case of a single buyer who can purchase the good from multiple sellers, and Chiu and Koeppl (2016) and Maurin (2018) for the case of random search. In the latter case, each buyer meets a single seller and optimally posts a price (see Samuelson 1984).…”

Bailout Stigma

“…In this section, we evaluate alternative bailout equilibria and characterize the optimal bailout term p g , with the cost of bailouts explicitly accounted for. To model the cost, we follow the literature (Tirole, 2012;Chiu and Koeppl, 2016) and assume that raising a dollar of public funds used for the asset purchase program costs the society (1 + λ) dollars, where λ ≥ 0 represents the deadweight loss of raising public funds, e.g., distortionary taxation. The welfare effect of a bailout policy would be then captured by the investment surplus generated by the policy minus the total cost of raising public funds that the policy would incur.…”

The Incentive Channel of Capital Market Interventions

“…This result differs from Fuchs and Skrzypacz (2015), who study a setting with fixed asset quality but dynamic trading and show that it is optimal to intervene as soon as possible. Chiu and Koeppl (2016) show that waiting to intervene be optimal in settings with fixed asset quality and search frictions. Their result is based on the notion that future interventions increase selling pressure in frictional markets today, alleviating adverse selection and giving rise to an announcement effect that can be exploited by regulators.…”