Trading Dynamics in Decentralized Markets with Adverse Selection

59 Pages Posted: 6 Sep 2011

See all articles by Benjamin R. Lester

Benjamin R. Lester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Braz Camargo

University of Western Ontario - Department of Economics

Date Written: July 29, 2011

Abstract

The authors study a dynamic, decentralized lemons market with one-time entry and characterize its set of non-stationary equilibrium. This framework offers a theory of how a market suffering from adverse selection recovers over time endogenously; given an initial fraction of lemons, the model provides sharp predictions about how prices and the composition of assets evolve over time. Comparing economies in which the initial fraction of lemons varies, the authors study the relationship between the severity of the lemons problem and market liquidity. They use this framework to understand how asymmetric information contributed to the breakdown in trade of asset{backed securities during the recent financial crisis, and to evaluate the efficacy of one policy that was implemented in attempt to restore liquidity.

Keywords: Adverse Selection, Decentralized Trade, Liquidity, Market Freeze and Re- covery

Suggested Citation

Lester, Benjamin R. and Camargo, Braz, Trading Dynamics in Decentralized Markets with Adverse Selection (July 29, 2011). FRB of Philadelphia Working Paper No. 11-36, Available at SSRN: https://ssrn.com/abstract=1923304 or http://dx.doi.org/10.2139/ssrn.1923304

Benjamin R. Lester (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

HOME PAGE: http://sites.google.com/site/benjaminrlester

Braz Camargo

University of Western Ontario - Department of Economics ( email )

London, Ontario N6A 5B8
Canada

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