Information Chasing versus Adverse Selection

Abstract

Contrary to the prediction of the classic adverse selection theory, more informed traders could receive better pricing relative to less informed traders in over-the-counter financial markets. Dealers actively chase informed orders to better position their future quotes and avoid winner's curse in subsequent trades. On a multi-dealer platform, dealers' incentive of information chasing exactly offsets their fear of adverse selection. In a more general setting, information chasing can dominate adverse selection when dealers face differentially informed speculators, while adverse selection dominates when dealers face differentially informed trades from a given speculator. These two seemingly contrasting predictions are supported by empirical evidence from the UK government bond market.