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Strategic Liquidity Supply and Security Design

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  • Bruno Biais
  • Thomas Mariotti

Abstract

We study how securities and trading mechanisms can be designed to optimally mitigate the adverse impact of market imperfections on liquidity. Asset owners seek to obtain liquidity by selling their claims on future cash-flows, on which they have private information. Our analysis encompasses both the cases of competitive and monopolistic liquidity supply. In the optimal trading mechanism associated to an arbitrary given security, issuers with low cash-flows sell their entire holdings of the security, while issuers with larger cash-flows are typically excluded from trade. By designing the security optimally, issuers can eshew exclusion altogether. 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 low cash-flows.

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Bibliographic Info

Paper provided by Suntory and Toyota International Centres for Economics and Related Disciplines, LSE in its series STICERD - Theoretical Economics Paper Series with number 445.

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Date of creation: Jan 2003
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Handle: RePEc:cep:stitep:445

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Web page: http://sticerd.lse.ac.uk/_new/publications/default.asp

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Keywords: Security design; liquidity; mechanism design; adverse selection; financial markets imperfections.;

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Citations

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Cited by:
  1. Biais, Bruno & Glosten, Larry & Spatt, Chester, 2004. "Market Microstructure: A Survey of Microfoundations, Empirical Results, and Policy Implications," IDEI Working Papers 253, Institut d'Économie Industrielle (IDEI), Toulouse.
  2. 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.
  3. Attar, Andrea & Mariotti, Thomas & Salanié, François, 2009. "Non-Exclusive Competition in the Market for Lemons," IDEI Working Papers 558, Institut d'Économie Industrielle (IDEI), Toulouse.
  4. 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.
  5. Inderst, Roman & Mueller, Holger M, 2005. "Informed Lending and Security Design," CEPR Discussion Papers 5185, C.E.P.R. Discussion Papers.
  6. 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.
  7. Inderst, Roman & Mueller, Holger M, 2003. "Credit Risk Analysis and Security Design," CEPR Discussion Papers 3686, C.E.P.R. Discussion Papers.
  8. James Dow & Gary Gorton, 2006. "Noise Traders," NBER Working Papers 12256, National Bureau of Economic Research, Inc.

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