Limelight on Dark Markets: Theory and Experimental Evidence on Liquidity and Information

Abstract:

This paper investigates how informational frictions affect asset liquidity in OTC markets both in theory and in a laboratory setting. Subjects, matched pairwise at random, trade divisible commodities that have different private values for a divisible asset with a common value. The asset’s role as a medium of exchange can be affected by its lack of "recognizability." The benchmark is a two-dimensional OTC bargaining game with complete information. In the adverse selection experiments, some subjects have private information about the asset’s terminal value. In the hidden action experiment, some subjects can produce fraudulent assets at some cost. Finally, we allow subjects to choose their holdings of the liquid asset, where the asset can vary in terms of its rate of return and recognizability property.