Insiders, Outsiders, and Market Breakdowns

Abstract

A simple classical Walrasian framework is proposed for the study of manipulation among asymmetrically informed risk-averse traders in financial markets, and it is used to analyze the occurrence of a market breakdown in the trading system. Such a phenomenon occurs when the outsiders refuse to trade with the insiders because the informational motive for trade of the insider outweighs her hedging motive. We demonstrate the robustness of our results by proving that the market collapse condition extends not only to the linear strategy function, but to the whole class of feasible nonlinear strategy functions. Implications for insider-trading regulation are sketched.