Adverse Selection, Search Frictions and Endogenous Market Structure
41 Pages Posted: 28 Jan 2019
Date Written: January 16, 2019
A large number of financial assets are traded in both exchanges and over-the-counter markets (i.e., centralized and decentralized markets, CM and DM hereafter, respectively). Moreover, the last century has witnessed the secular migration of asset trading from CM to DM. To this end, this paper develops a tractable model on strategic selection of venue trading to study the causes and consequences of endogenous coexistence of CM and DM. We show that as matching efficiency in DM increases and the information cost decreases, more trade migrates from CM with adverse selection to DM with search frictions. This finding reveals that investigating implications of adverse selection requires considering the endogenous market structure. Moreover, we find that reducing informational asymmetry with costly information acquisition may be detrimental to welfare. We then apply the model to evaluate the heterogeneous treatment effect of the government asset purchase program initiated after the global financial crisis.
Keywords: Exchange vs OTC, Fragmented Financial Markets, Adverse Selection, Search Frictions, Screening
JEL Classification: D61, D82, D83, L10
Suggested Citation: Suggested Citation