Abstract

Speculation creates an adverse selection cost for utility traders, who will choose not to trade if this cost exceeds the benefits of using the asset market. However, if they do not participate, the market collapses, since private information alone is not sufficient to create a motive for trade. There is, therefore, a limit to the number of speculative transactions that a given market can support. This paper compares this limit in decentralized, monopoly-intermediated and competitively-intermediated market regimes, finding that the second regime is best equipped to deal with speculation: an informed monopolist can price-discriminate investors and thus always avoid market breakdowns. These regimes are also compared in terms of welfare and trading volume. The analysis suggests a reason for the presence of intermediaries in financial markets. © 2003 Elsevier Inc. All rights reserved.