The Double Bind of Asymmetric Information in Over-the-Counter Markets

Abstract

In over-the-counter markets with heterogeneous asset qualities and individual valuations, private information about both of these value components amplifies the adverse selection problem attributable only to privately known asset quality. Specifically, when gains from trade are low, asymmetric information creates a double bind: either the market breaks down due to a classic lemons problem or low-quality assets are traded excessively, generating a congestion externality. A market designer may improve efficiency without incurring losses by acquiring all assets, issuing asset-backed securities of publicly known quality and capturing at least a part of the surplus from the future trades of these securities.