Information Chasing versus Adverse Selection in Over-the-Counter Markets
Posted: 9 Sep 2020
Date Written: July 28, 2020
Contrary to the prediction of the classic adverse selection theory, informed speculators receive better pricing relative to uninformed liquidity traders in over-the-counter financial markets. Dealers compete for information by chasing informed orders so as to better position their future price quotes. On a multi-dealer platform, dealers' incentive of information chasing exactly offsets their fear of adverse selection. Through information chasing, dealers transform adverse selection by the informed into winner's curse when bidding for the uninformed. As a result, the adverse selection cost is entirely passed on to liquidity traders. Price dispersion and bid-ask spread endogenously arise from winner's curse. Both price dispersion and price efficiency increase with the mass of liquidity traders. As long as speculators have slightly correlated signals, they trade with the same dealer in equilibrium, giving rise to an information monopolist despite direct competition among the dealers. Post-trade transparency reduces information chasing incentive and thus price efficiency.
Keywords: Information Chasing, Adverse Selection, Over-the-Counter, Multi-Dealer Platform, Winner’s Curse, Pre-Trade and Post-Trade Transparency, Price Efficiency, Price Dispersion, Information Concentration
JEL Classification: G14, G18, D82
Suggested Citation: Suggested Citation