Adverse Selection in the Equity Loans Market
18 Pages Posted: 25 Jul 2016 Last revised: 5 Sep 2018
Date Written: July 25, 2017
We examine a form of adverse selection which arises when short sellers attempt to coordinate a price correction, but stock lenders learn by observing arbitrageurs’ arrivals and become better informed about the true timing of an imminent price correction. We refer to this concept as coarse clocks. We show how coarse clocks lead to an adverse selection problem in the market for equity loans, creating a type of strategic short sale constraint which limits arbitrage. We analyze the implications of a switch from the current over-the-counter stock loans market to a centralized exchange, and relate our findings to recent empirical research on short-selling risks.
Keywords: short selling risk, recall risk, limits of arbitrage, adverse selection, equity loan market, short sales, coordination games, learning
JEL Classification: G10, D82, D83
Suggested Citation: Suggested Citation