Insiders, Outsiders, and Market Breakdowns

What is it about?

A simple classical framework is proposed for the study of manipulation among asymmetrically informed risk-averse traders in financial markets, and it is used to analyze the occurrence of a market breakdown in the trading system. Such a phenomenon occurs when the outsiders refuse to trade with the insiders because the informational motive for trade of the insider outweighs her hedging motive. We demonstrate the robustness of our results by proving that the market collapse condition extends not only to the linear strategy function, but to the whole class of feasible nonlinear strategy functions. Implications for insider-trading regulation are sketched.

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Why is it important?

It was well known that trades do not happen if information is the only motive for trade. People will not trade because the other party may have inside information. It was also well known that trades happen if risk-sharing is the only motive for trade. This paper is the first paper to combine the two motives, and characterize the point where trade breaks down.

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