Trading Dynamics in Decentralized Markets with Adverse Selection

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.