Information Asymmetry and Market Fragmentation

Cecilia Parlatore and Ana Babus

No 1306, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: We explore the role of information asymmetries and learning as a source of market fragmentation. In our model, the equilibrium market structure is driven by the interaction between information asymmetries and the differences in the trading needs of investors. Dealers open trading posts and investors choose in which trading post to trade. After the market structure is decided, trade takes place sequentially. First, in each trading post, each dealer and his investors trade strategically. Second, after trading with their investors, dealers have access to a competitive inter-dealer market. Dealers learn about the fundamental value of the asset by providing liquidity to investors. Then they use this information to decide how much inventory they carry to the inter-dealer market. Although the price is fully revealing in the inter-dealer market, dealers trade to share their inventory risk. If dealers are perfectly informed trade takes place in a unique centralized market. As the degree of information asymmetry between dealers and investors increases, trading moves from a centralized market to fragmented markets. This is more likely when investor's private valuations are less dispersed. The mechanism is as follows. When choosing how to trade investors weight the gains from trade from having more market participants against their market power. As prices become more informative dealers trade more aggressively which increases the investors' market power for a given market size. Moreover, if investors' valuations are highly correlated, investors value having market power more than trading in a bigger market. This gives rise to fragmented markets. The model also has implications for price dispersion and liquidity.

Date: 2015
New Economics Papers: this item is included in nep-mst
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