Presenter: James Dow, London Business School

Title: Does Informed Trading Enhance or Impair Market Liquidity?

Abstract: A common (mis?) conception is that informed traders reduce liquidity by driving out uninformed trade, through a “lemons” or “cream-skimming” effect. However, this is an oversimplification. The lemons effect is offset by another effect, the “endogenous asymmetric information effect.” Informed traders may indeed deter uninformed traders by making money at their expense. So, more informed traders can reduce trading by uninformed traders (lemons effect). But there is a another effect that works in the opposite direction: more informed trade tends to make prices more informative. Therefore, in equilibrium the amount of asymmetric information, conditional on the price, is smaller than before trading commenced. In turn, this reduces the monetary transfer from uninformed to informed traders, and tends to increase trading by uninformed traders. Therefore, more informed traders may end up encouraging more uninformed trade (the endogenous asymmetric information effect may outweigh the lemons effect).

Host: Matthias Lassak