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Trading dynamics in decentralized markets with adverse selection

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  • Camargo, Braz
  • Lester, Benjamin

Abstract

We study a dynamic, decentralized lemons market with one-time entry and characterize its set of equilibria. Our framework offers a theory of how “frozen” markets suffering from adverse selection recover or “thaw” over time endogenously; given an initial fraction of lemons, our model delivers sharp predictions about the length of time it takes for the market to recover, and how prices and the composition of assets in the market behave over this horizon. We use our framework to analyze a form of government intervention introduced during the recent financial crisis in order to help unfreeze the market for asset-backed securities. We find that, depending on the fraction of lemons in the market, such an intervention can speed up or slow down market recovery. More generally, our analysis highlights that the success of an intervention in a lemons market depends on both its size and duration.

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  • Camargo, Braz & Lester, Benjamin, 2014. "Trading dynamics in decentralized markets with adverse selection," Journal of Economic Theory, Elsevier, vol. 153(C), pages 534-568.
    • Handle: RePEc:eee:jetheo:v:153:y:2014:i:c:p:534-568
    DOI: 10.1016/j.jet.2014.07.013
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    More about this item

    Keywords

    Adverse selection; Decentralized trade; Liquidity; Market freeze and recovery;
    All these keywords.

    JEL classification:

    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • G1 - Financial Economics - - General Financial Markets

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