Review of Economic Studies (2015) 00, 1–35 0034-6527/15/00000001$02.00 c 2015 The Review of Economic Studies Limited Trading Dynamics with Adverse Selection and Search: Market Freeze, Intervention and Recovery JONATHAN CHIU Bank of Canada Victoria University of Wellington THORSTEN V. KOEPPL Department of Economics, Queen’s University First version received August 2011; final version accepted October 2015 (Eds.) We study trading dynamics in an asset market where the quality of assets is private information and finding a counterparty takes time. When trading ceases in equilibrium as a response to an adverse shock to asset quality, a government can resurrect trading by buying up lemons which involves a financial loss. The optimal policy is centred around an announcement effect where trading starts already before the intervention for two reasons. First, delaying the intervention allows selling pressure to build up thereby improving the average quality of assets for sale. Second, intervening at a higher price increases the return from buying an asset of unknown quality. It is optimal to intervene immediately at the lowest price when the market is sufficiently important. For less important markets, when the shock to quality and search frictions are small, it is optimal to rely on the announcement effect. Here delaying the intervention and fostering the effect by intervening at the highest price tend to be complements. Key words : Adverse Selection, Search, Trading Dynamics, Government Asset Purchases, Announcement Effect JEL Codes : G1, E6 1. INTRODUCTION This paper uses asymmetric information and search to understand trading dynamics in financial markets and studies the optimal design of government asset purchase programs when such frictions are present. During the recent financial crisis, there was a stunning difference in market performance. Markets for transparent assets and with centralized trading functioned well. To the contrary, in over-the-counter (OTC) markets – where trading takes place on a decentralized basis and where assets are opaque in the sense that they vary widely in their characteristics – trading came to a halt. Most prominently, collateralized debt obligations, asset backed securities and commercial paper were traded only sporadically or not at all (see Gorton and Metrick, 2012). This market freeze is commonly linked to a reassessment by market participants of the average quality of the assets traded in these markets. 1 Among other measures, governments reacted to this situation by purchasing distressed assets in these markets. These asset purchase programs, however, had to be set up with little guidance for how to design them. Our goal is to provide guidance for how to design asset purchase programs that seek to restore trading in asset markets. We start by exploring the reason for why asset markets are fragile when trading is decentralized. In many financial markets, assets are traded 1. For example, Moody’s Investor Service (2010) reports large spikes in impairment probabilities for structured debt products across all ratings and products for 2007 to 2009. 1