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Strategic Liquidity Supply and Security Design

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  • Bruno Biais
  • Thomas Mariotti

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 2005, Wiley-Blackwell.

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Article provided by Oxford University Press in its journal The Review of Economic Studies.

Volume (Year): 72 (2005)
Issue (Month): 3 ()
Pages: 615-649

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Handle: RePEc:oup:restud:v:72:y:2005:i:3:p:615-649

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Cited by:
  1. Inderst, Roman & Mueller, Holger M, 2003. "Credit Risk Analysis and Security Design," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3686, C.E.P.R. Discussion Papers.
  2. Inderst, Roman & Vladimirov, Vladimir, 2014. "Preserving "Debt Capacity" or "Equity Capacity": A Dynamic Theory of Security Design under Asymmetric Information," CEPR Discussion Papers, C.E.P.R. Discussion Papers 9923, C.E.P.R. Discussion Papers.
  3. Abdelhamid, El Bouhadi & Omar, Essardi, 2007. "Micro-microcrédit et asymétries d’information : cas du Maroc
    [INFORMATION asymmetries and microcredit: The Moroccan case]
    ," MPRA Paper 20080, University Library of Munich, Germany.
  4. Silvia Rossetto, 2013. "IPO activity and information in secondary market prices," Annals of Finance, Springer, Springer, vol. 9(4), pages 667-687, November.
  5. James Dow & Gary Gorton, 2006. "Noise Traders," NBER Working Papers 12256, National Bureau of Economic Research, Inc.
  6. Roman Inderst & Holger M. Mueller, 2006. "Informed Lending and Security Design," Journal of Finance, American Finance Association, American Finance Association, vol. 61(5), pages 2137-2162, October.
  7. Attar, Andrea & Mariotti, Thomas & Salanié, François, 2009. "Non-Exclusive Competition in the Market for Lemons," TSE Working Papers, Toulouse School of Economics (TSE) 09-055, Toulouse School of Economics (TSE).
  8. Sohnke M. Bartram & Frank R. Fehle, 2003. "Competition among Alternative Option Market Structures: Evidence from Eurex vs. Euwax," Finance, EconWPA 0307005, EconWPA, revised 24 Jul 2003.
  9. Biais, Bruno & Declerck, Fany, 2007. "Liquidity, Competition & Price Discovery in the European Corporate Bond Market," IDEI Working Papers, Institut d'Économie Industrielle (IDEI), Toulouse 475, Institut d'Économie Industrielle (IDEI), Toulouse.
  10. Malamud, Semyon & Rui, Huaxia & Whinston, Andrew, 2013. "Optimal incentives and securitization of defaultable assets," Journal of Financial Economics, Elsevier, Elsevier, vol. 107(1), pages 111-135.

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