Cream Skimming in Financial Markets

Abstract

We propose a model where investors can choose to acquire costly information that allows them to identify good assets and purchase them in opaque over the counter (OTC) markets. Uninformed investors trade on an organized exchange and only have access to an asset pool that has been (partially) cream-skimmed by informed dealers. We show that when the quality composition of assets for sale is fixed there is always too much information acquisition and cream skimming by dealers in equilibrium. In the presence of moral hazard in origination, we show that the social value of information acquisition and trading by dealers varies inversely with private incentives to acquire information: just when it is socially optimal to limit costly investment in information by dealers, investors' private incentives to acquire information are at their highest, and vice-versa. Thus, equilibrium entry by informed dealers in OTC markets is generically inefficient.

JEL Classification: G10, G14