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Strategic liquidity supply and security design

  • Bruno Biais
  • Thomas Mariotti

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/
File Function: Open access version.
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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
Contact details of provider: Postal: LSE Library Portugal Street London, WC2A 2HD, U.K.
Phone: +44 (020) 7405 7686
Web page: http://www.lse.ac.uk/

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