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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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File URL: http://eprints.lse.ac.uk/19323/
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Bibliographic Info

Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 19323.

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Length: 39 pages
Date of creation: Jan 2003
Date of revision:
Handle: RePEc:ehl:lserod:19323

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

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References

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Citations

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Cited by:
  1. Inderst, Roman & Vladimirov, Vladimir, 2012. "Preserving "Debt Capacity" or "Equity Capacity": A Dynamic Theory of Security Design under Asymmetric Information," MPRA Paper 53840, University Library of Munich, Germany.
  2. Andrea Attar & Thomas Mariotti & François Salanié, 2010. "Non-Exclusive Competition in the Market for Lemons," CEIS Research Paper 159, Tor Vergata University, CEIS, revised 28 May 2010.
  3. Inderst, Roman & Mueller, Holger M, 2003. "Credit Risk Analysis and Security Design," CEPR Discussion Papers 3686, C.E.P.R. Discussion Papers.
  4. Malamud, Semyon & Rui, Huaxia & Whinston, Andrew, 2013. "Optimal incentives and securitization of defaultable assets," Journal of Financial Economics, Elsevier, vol. 107(1), pages 111-135.
  5. Silvia Rossetto, 2013. "IPO activity and information in secondary market prices," Annals of Finance, Springer, vol. 9(4), pages 667-687, November.
  6. Roman Inderst & Holger M. Mueller, 2006. "Informed Lending and Security Design," Journal of Finance, American Finance Association, vol. 61(5), pages 2137-2162, October.
  7. James Dow & Gary Gorton, 2006. "Noise Traders," NBER Working Papers 12256, National Bureau of Economic Research, Inc.
  8. 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.

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