Information Acquisition and Liquidity Trap in OTC Markets

Abstract: I analyze the interaction between buyers' endogenous information acquisition and market liquidity in over-the-counter markets where sellers are privately informed of the asset quality. When buyers acquire information and provide quotes based on inaccurate signals, high quality assets are sold faster because sellers with low quality assets are willing to wait for good quotes. This effect lowers future market liquidity and increases the value of information to the current buyers. In fact, without any fundamental shock, the market can transit from a liquid steady state to a less liquid, absorbing steady state. This finding is consistent with the increased level of due diligence and the declined liquidity in the non-agency residential mortgage-backed-security market even after the recovery of the housing market. I also show that increasing issuance transparency have non-monotonic effect on the liquidity of the secondary market.

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