One of my favorite scenes from Michael Lewis's The Big Short is a great illustration of how adverse selection or fear of adverse selection can prevent a market from operating and how noise traders open the market.
Steve Eisman wants to bet against subprime. Greg Lippmann wants to sell him that bet. But Eisman and his partners hold back. They keep asking what does this guy know that we don't? Why is he selling us this great deal? Could it really be this obvious? Could it really be this simple? Over and over again they questions Lippmann and themselves. "Greg," says Eisman's partner, "Don't take this the wrong way. But I'm just trying to figure out how you're going to fuck me."
Everything is telling Eisman that this is the bet of the century but fear that he is missing something, that the other guy is smarter than he is, still holds him back. Finally, Lippmann hits on an unusual idea, he invites Eisman, who wants to short subprime, to meet with the buyers of subprime.
The teppanyaki room inside the Okada restaurant consisted of four islands, each with a large, cast-iron hibachi and dedicated chef. Around each island Lippmann seated a single hedge fund manager whom he had persuaded to short subprime bonds, along with investors who were long those same bonds. The hedge fund people, he hoped, would see just how stupid the investors on the other side of those bets were and cease to worry that the investors knew something they did not.
Lippmann's plan works. Eisman meets the buyers and for the first time groks the stupidity that is ruling the market and he makes the trades that will make him and his partners rich.