Quick definition Information asymmetry occurs when one party in a trade has better information than the other party. The informed party has an advantage and can execute more profitable trades. What it is In a perfectly transparent market, all participants would have the same information. In reality, some traders have better information. A day trader might have analysed the company; a retail trader might not. A fund manager might have a proprietary model; an individual investor might not. Information asymmetry is the rule, not the exception. The existence of information asymmetry is why market makers need compensation in the form of bid-ask spreads. Why it matters Information asymmetry creates costs for uninformed traders. Market makers assume that many traders have superior information. To compensate for this risk, they widen spreads. The spread is partly compensation for trading against potentially informed traders. Extreme information asymmetry (like insider trading) is illegal. Moderate information asymmetry is normal and unavoidable. Information asymmetry versus insider trading Information asymmetry is when one party has better information than another. Insider trading is when someone uses non-public information to trade illegally. All insider trading involves information asymmetry, but not all information asymmetry involves insider trading. A trader with a better public analysis tool has information asymmetry against retail traders. An executive trading on non-public information has information asymmetry and is committing insider trading. Practical example You are a market maker in a stock. You assume that some traders have analysed the company more thoroughly than you have. These traders might know the company has strong earnings. You widen your spread to 2 cents to compensate for the risk that you trade with an informed trader. A retail investor places a market buy order at your ask. They have not analysed the company and are buying randomly. You have no information asymmetry here; you are not trading against someone with superior information. Screening for informed traders Market makers cannot perfectly identify informed traders. They use statistical methods to estimate whether their counterparty is likely to be informed. If they notice a particular trader is consistently profitable, they assume that trader is informed and widen spreads. See also - Adverse Selection - Insider Trading - Price Discovery - Market Maker
