Security Design in Opaque Markets: The Role of Exclusivity and Commitment

We study the problem of a seller with private information about her asset quality who can design securities backed by her asset cashflows to raise funds from investors in non-exclusive markets. When markets are non-exclusive, bilateral contracts between the seller and a particular investor cannot be made contingent on the contracts traded with other investors. This feature is natural in an opaque marketplace or in a dynamic environment where commitment is limited. We show that in such an environment full separation of seller types cannot be obtained. In any equilibrium, all seller types issue the same debt contract. While high-quality types retain the remaining cashflows on their balance sheet, low-quality sellers tranche their cash flows and sell the debt contract (senior tranche) and the remaining cashflows (junior tranche) separately to different investors. The model can rationalize the practice of tranching securities, and it generates new empirical predictions on the relation between the types of securities sold in markets and the quality of their underlying assets.