Adverse Selection, Search Frictions and Endogenous Market Structure

41 Pages Posted: 28 Jan 2019

See all articles by Feng Dong

Feng Dong

Tsinghua University - School of Economics and Management

Date Written: January 16, 2019

Abstract

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

Dong, Feng, Adverse Selection, Search Frictions and Endogenous Market Structure (January 16, 2019). Available at SSRN: https://ssrn.com/abstract=3316565 or http://dx.doi.org/10.2139/ssrn.3316565

Feng Dong (Contact Author)

Tsinghua University - School of Economics and Management ( email )

School of Economics and Management
Tsinghua University
Beijing, Beijing 100084
China

HOME PAGE: http://fengdongecon.weebly.com

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