Journal Article

Strategic Liquidity Supply and Security Design

Bruno Biais and Thomas Mariotti

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 72, issue 3, pages 615-649
Published in print July 2005 | ISSN: 0034-6527
Published online July 2005 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2005.00345.x
Strategic Liquidity Supply and Security Design

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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.

Keywords: G32

Journal Article.  18555 words.  Illustrated.

Subjects: Corporate Governance

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