Working Paper

An Information-Based Theory of Financial Intermediation

Abstract: We advance a theory of how private information and heterogeneous screening ability across market participants shapes trade in decentralized asset markets. We solve for the equilibrium market structure and show that the investors who intermediate trade the most and interact with the largest set of counterparties must have the highest screening ability. That is, the primary intermediaries are those with superior information?screening experts. We provide empirical support for the model?s predictions using transaction-level micro data and information disclosure requirements. Finally, we study the connection between screening ability and efficiency, and observe that a market where all investors are screening experts?and thus, a market with no private information?may be dominated in terms of welfare by a market with no screening experts.

Keywords: Over-the-counter markets; intermediation; private information;

JEL Classification: D53; D82; G14;

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Bibliographic Information

Provider: Federal Reserve Bank of Richmond

Part of Series: Working Paper

Publication Date: 2019-07-02

Number: 19-12

Pages: 71 pages