Asymmetric Information and Liquidity Provision

Abstract

The presence of information asymmetry increases the probability that a potential predator will provide liquidity rather than engaging in predatory trading during liquidation by a distressed trader. More information asymmetry is associated with lower expected losses from liquidation for the distressed trader in illiquid markets. There is a negative correlation between the degree of information asymmetry and the returns from predatory trading, which is consistent with empirical findings. These results imply that strategic traders are more likely to stabilize markets by providing liquidity when information is asymmetric. These findings highlight a cost associated with disclosure and can explain the documented rarity of illiquidity episodes in financial markets.

Keywords: Asymmetric information, Predatory trading, Illiquidity, Regulation

JEL Classification: G10, G11, G23, G28, C72, D43