Strategic liquidity supply and security design

Bruno Biais and Thomas Mariotti

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

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.

Keywords: Security design; liquidity; mechanism design; adverse selection; financial markets imperfections (search for similar items in EconPapers)
JEL-codes: G32 L14 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2003-01
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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http://eprints.lse.ac.uk/19323/ Open access version. (application/pdf)

Related works:
Journal Article: Strategic Liquidity Supply and Security Design (2005)
Working Paper: Strategic Liquidity Supply and Security Design (2004)
Working Paper: Strategic Liquidity Supply and Security Design (2003)
Working Paper: Strategic Liquidity Supply and Security Design (2002)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:19323

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