Adverse Selection, Search Frictions and Liquidity in Financial Markets

Venky Venkateswaran, Ariel Zetlin-Jones, Ali Shourideh and Benjamin Lester

No 1438, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: We study a dynamic financial market where informed traders meet and trade with marketmakers in bilateral interactions. In such an environment, market liquidity, summarized by the bid-ask spread, is determined jointly by the two primitive forces, namely search frictions (as in Duffie et. al., 2005) and asymmetric information (in the spirit of Glosten and Milgrom, 1985). We show that their interaction leads to novel and surprising implications, both positive and normative. Reducing trading frictions, for example, exacerbates the effects of asymmetric information, which can lead to lower liquidity and welfare. More transparency increases the distortions from market-power and also has negative liquidity/welfare consequences. These results point to the value of a unified framework with both frictions for evaluating the effects of policies.

Date: 2016
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