Security Design: Signaling Versus Speculative Markets

60 Pages Posted: 18 Apr 2011

See all articles by Gilles Chemla

Gilles Chemla

Imperial College Business School; CNRS ; Centre for Economic Policy Research (CEPR)

Chris Hennessy

London Business School

Date Written: April 2011

Abstract

We determine optimal security design and retention of asset-backed securities by a privately informed issuer with positive NPV uses for immediate cash. In canonical models, investors revert to prior beliefs if issuers pool at zero-retentions (originate-to-distribute), and separating equilibria are welfare-dominated since separation entails signaling via asset-retention and underinvestment. However, we show speculative markets arise if and only if issuers pool, creating previously overlooked costs. Pooling induces socially costly information acquisition by speculators. Further, in pooling equilibria, issuers never sell safe claims, leaving uninformed investors exposed to adverse selection and distorting risk sharing. In such equilibria, issuers retain zero interest in the asset, and speculator effort is maximized by splitting cash flow into a risky senior ("debt") tranche and residual junior ("equity") claim. Optimal leverage trades off per-unit speculator gains against endogenous declines in uninformed debt trading. Issuer incentives to implement the pooling equilibrium, with distorted risk sharing, are strong precisely when efficient risk sharing, achieved through separation, has high social value. In such cases, a tax on issuer proceeds can raise welfare by encouraging issuer retentions. Taxation dominates mandatory skin-in-the-game as a policy response, since the latter creates gratuitous underinvestment.

Keywords: issuer, pooling, security design, separating, speculator, type

JEL Classification: G21, G32

Suggested Citation

Chemla, Gilles and Hennessy, Christopher, Security Design: Signaling Versus Speculative Markets (April 2011). CEPR Discussion Paper No. DP8336. Available at SSRN: https://ssrn.com/abstract=1810299

Gilles Chemla (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom
+44 207 594 9161 (Phone)
+44 207 594 9210 (Fax)

CNRS ( email )

Dauphine Recherches en Management
Place du Marechal de Lattre de Tassigny
Paris, 75016
France
331 44054970 (Phone)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Christopher Hennessy

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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