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Strategic Liquidity Supply and Security Design

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Author Info
Biais, Bruno
Mariotti, Thomas

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Abstract

We study how securities and trading mechanisms can be designed to mitigate the adverse impact of market imperfections on liquidity. Following De Marzo and Duffie (1999), we consider asset owners who seek to obtain liquidity by selling their claims on future cash-flows, on which they have private information. We allow for strategic liquidity supply and take a mechanism design approach to characterize both the optimal security and the optimal trading mechanism. For a given arbitrary security, issuers with cash-flows below a threshold entirely sell their holdings of the securities, while issuers with larger cash-flows are excluded from trading. The optimal security design entirely avoids this partial market breakdown phenomenon. We find 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, it reduces the ability of strategic liquidity suppliers to exclude them from trade to better extract rents from agents with lower cash-flows. We also show that competition in non-exclusive schedules between finitely many oligopolistic liquidity suppliers implements the competitive trading mechanism.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3369.

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Date of creation: May 2002
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Handle: RePEc:cpr:ceprdp:3369

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Related research
Keywords: adverse selection; liquidity; mechanism design; security design;

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Find related papers by JEL classification:
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure
L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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References listed on IDEAS
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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. James Dow & Gary Gorton, 2006. "Noise Traders," NBER Working Papers 12256, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Inderst, Roman & Mueller, Holger M, 2005. "Informed Lending and Security Design," CEPR Discussion Papers 5185, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  3. 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!]
  4. 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!]
  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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