Trading Dynamics with Adverse Selection and Search: Market Freeze, Intervention and Recovery

Abstract

We study the trading dynamics in an asset market where the quality of assets is private information of the owner and nding a counterparty takes time. When trading of a nancial asset ceases in equilibrium as a response to an adverse shock to asset quality, a large player can resurrect the market by purchasing bad assets which involves nancial losses. The equilibrium response to such a policy is intricate as it creates an announcement eect: a mere announcement of intervening at a later point in time can cause markets to function again. This eect leads to a gradual recovery in trading volume, with asset prices converging non-monotonically to their normal values. The optimal policy is to intervene immediately at a minimal scale when markets are deemed important and losses are small. As losses increase and the importance of the market declines, the optimal intervention is delayed and it can be desirable to rely more on the announcement eect by increasing the size of the intervention. Search frictions are important for all these results. They compound adverse selection, making a market more fragile with respect to a classic lemons problem. They dampen the announcement eect and cause the optimal policy to be more aggressive, leading to an earlier intervention at a larger scale.