Adverse Selection and Intermediation Chains

Abstract

We propose a parsimonious model of over-the-counter trading with asymmetric information to rationalize the existence of intermediation chains that stand between buyers and sellers of assets. Trading an asset through several heterogeneously informed intermediaries can preserve the efficiency of trade by reallocating an information asymmetry over many sequential transactions. Such an intermediation chain ensures that the adverse selection problems counterparties face in each transaction are small enough to allow for socially efficient trading strategies by all parties involved. Our model makes novel predictions about network formation and rent extraction when adverse selection problems impede the efficiency of trade.

Keywords: Intermediation Chains, Asymmetric Information, OTC Trading Networks, Order-Flow Agreements, Information Percolation

JEL Classification: G20, D82, D85