Before a financial instrument can be sold in a securities exchange, involved parties must overcome the problem of adverse selection. Stocks most readily experience adverse selection in two forms: buyers tend to (but don't always) know less about the stock than issuers in the primary market, and risky stocks might appeal most to those who are least capable of surviving poor returns.

Traditionally, financial intermediaries mitigate or eliminate adverse selection in the stock market by reducing information costs. The advent of the Internet was a huge boon to the average investor, allowing speed and accuracy of information in ways never before realized.

There is one unique and controversial example of adverse selection in some secondary stock market trades: insider trading.

Insider Trading

Insider trading is a poorly defined concept with roots in adverse selection theory and the efficient market hypothesis (EMH). The popular notion is that insiders have an unfair advantage because they possess materially significant and non-public information – an informational asymmetry.

There are several problems with this notion. The first two are obvious: how is an insider defined, and what qualifies as an insider trade? Since stock exchanges and regulatory agencies don't want the investing public to believe the game is fixed, there are grounds for safeguards against insider transactions. This is far easier said than done.

Insiders have the best access to information and markets are most efficient when prices reflect accurate and up-to-date information. Prohibiting insiders from acting on information has the unfortunate consequence of keeping all traders in the dark.

Economists disagree about whether this qualifies as adverse selection. Even those who think so don't agree on necessary remedies.

The Significance of Financial Intermediaries

Financial intermediaries, such as financial advisers and brokers, reduce adverse selection in several ways. Intermediaries rate companies and their issues, for example, providing investors with key information about stock value and trustworthiness.

London-style stock exchanges create disclosure requirements for issuers in order to attract more traders. Each exchange has an incentive to foster an atmosphere of fair play.

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  1. Adverse Selection

    Adverse selection refers to the tendency of high-risk individuals ...
  2. Insider Information

    Insider information is a non-public fact regarding the plans ...
  3. Financial Intermediary

    A financial intermediary facilitates transactions between lenders ...
  4. Insider

    A director or senior officer of a company, as well as any person ...
  5. Adverse Action

    An action that denies an individual or business credit, employment, ...
  6. Adverse Credit History

    Adverse credit history is a track record of poor repayment history ...
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