Adverse Selection and Liquidity Distortion in Decentralized Markets
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Briana Chang: Northwestern University
No 403, 2012 Meeting Papers from Society for Economic Dynamics
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.
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