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Strategic Liquidity Supply and Security Design

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Author Info
Bruno Biais
Thomas Mariotti

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Abstract

We study how securities and issuance mechanisms can be designed to mitigate the adverse impact of market imperfections on liquidity. In our model, asset owners seek to obtain liquidity by selling claims contingent on privately observed future cash-flows. Liquidity suppliers can be competitive or strategic. In the optimal trading mechanism associated with an arbitrary given security, issuers with low cash-flows sell their entire holdings of the security, while issuers with high cash-flows are typically excluded from trade. By designing the security optimally, issuers can avoid exclusion altogether. We show that the optimal security is debt. Because of its low informational sensitivity, debt mitigates the adverse selection problem. Furthermore, by pooling all issuers with high cash-flows, debt also reduces the ability of a monopolistic liquidity supplier to exclude them from trade in order to better extract rents from issuers with lower cash-flows. Copyright The Review of Economic Studies Limited, 2005.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-937X.2005.00345.x
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Publisher Info
Article provided by Blackwell Publishing in its journal Review of Economic Studies.

Volume (Year): 72 (2005)
Issue (Month): 3 (07)
Pages: 615-649
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Handle: RePEc:bla:restud:v:72:y:2005:i:3:p:615-649

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Sohnke M. Bartram & Frank R. Fehle, 2003. "Competition among Alternative Option Market Structures: Evidence from Eurex vs. Euwax," Finance 0307005, EconWPA, revised 24 Jul 2003. [Downloadable!]
  2. Biais, Bruno & Declerck, Fany, 2007. "Liquidity, Competition & Price Discovery in the European Corporate Bond Market," IDEI Working Papers 475, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
  3. James Dow & Gary Gorton, 2006. "Noise Traders," NBER Working Papers 12256, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  4. Inderst, Roman & Mueller, Holger M, 2005. "Informed Lending and Security Design," CEPR Discussion Papers 5185, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  5. Inderst, Roman & Mueller, Holger M, 2003. "Credit Risk Analysis and Security Design," CEPR Discussion Papers 3686, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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