Strategic Liquidity Supply and Security Design

41 Pages Posted: 16 Jul 2008

See all articles by Bruno Biais

Bruno Biais

Centre for Economic Policy Research (CEPR)

Thomas Mariotti

University of Toulouse I

Multiple version iconThere are 2 versions of this paper

Date Written: January 2003

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.

JEL Classification: D20, D80, H11, H70, L22, P11

Suggested Citation

Biais, Bruno and Mariotti, Thomas, Strategic Liquidity Supply and Security Design (January 2003). LSE STICERD Research Paper No. TE445, Available at SSRN: https://ssrn.com/abstract=1160989

Bruno Biais (Contact Author)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Thomas Mariotti

University of Toulouse I ( email )

Toulouse, 31000
France

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