Essays on Frictional Financial Markets

This thesis uses theoretical approach to study various types of frictions in financial markets. In the first chapter, Information Acquisition and Liquidity Traps in OTC Markets, I analyze the interaction between buyers\u27 information acquisition and market liquidity in over-the-counter markets with adverse selection. If a buyer anticipates that future buyers will acquire information about asset quality, she has an incentive to acquire information to avoid buying a lemon that will be hard to sell later. However, when current buyers acquire information, they cream-skim the market, leaving a larger fraction of lemons for sale and giving future buyers an incentive to acquire information. A liquid market can go through a self-fulfilling market freeze when buyers start to acquire information. More importantly, if information acquisition continues for a long enough period of time, the market gets stuck in an information trap with low liquidity: information acquisition worsens the composition of assets remaining on the market, and the bad composition incentivizes information acquisition. This prediction helps explain why the market for non-agency residential mortgage-backed securities experienced a sudden drop in liquidity—as potential buyers realized the need for greater due diligence—but has remained essentially dormant despite a strong recovery in the housing market. In the second chapter, Intervention with Screening in Global Games, my coauthor Lin Shen and I propose a novel intervention program to reduce coordination failure. Compared with the conventional government-guarantee type of programs, such as demand deposit insurance, it incurs a lower cost of implementation and suffers less from moral hazard problems. The proposed program effectively screens agents based on their heterogeneous beliefs of the coordination results. In equilibrium, only a small mass of pivotal agents self-select to participate in the program. However, the effect is amplified by strategic complementarities, and coordination failure can be significantly reduced. We demonstrate the generality of the proposed program with applications in panic-based bank runs, debt rollover problems, self-fulfilling market freezes, and underinvestment problems in the real economy