Information, Liquidity and Asset Trading in a Random Matching Game

This paper shows that the extent of information available in the market about a security can crucially affect its liquidity. Following Kiyotaki and Wright (1989), exchange is modeled as a sequential random matching game. Agents who want to consume relatively early optimally choose to exchange their initial assets for a new asset that has lower expected payoff but is more liquid in subsequent trading. This incentive to pay a premium for liquidity is further analyzed by allowing agents to credibly disclose more about their assets at a cost. Alternative intermediated mechanisms for increasing liquidity such as certification of assets by an investment bank, pooling assets in mutual funds, and introducing commercial banks are also discussed.