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Strategic Liquidity Supply and Security Design

  • Biais, Bruno
  • Mariotti, Thomas

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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Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 160.

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Date of creation: 2003
Date of revision: Mar 2004
Publication status: Published in The Review of Economic Studies, vol.�72, n°3, juillet 2005, p.�615-649.
Handle: RePEc:ide:wpaper:1580
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