Strategic Liquidity Supply and Security Design

Abstract

We study how securities and trading mechanisms can be designed to mitigate the adverse impact of market imperfections on liquidity. Following De Marzo and Duffie (1999), we consider asset owners who seek to obtain liquidity by selling their claims on future cash-flows, on which they have private information. We allow for strategic liquidity supply and take a mechanism design approach to characterize both the optimal security and the optimal trading mechanism. For a given arbitrary security, issuers with cash-flows below a threshold entirely sell their holdings of the securities, while issuers with larger cash-flows are excluded from trading. The optimal security design entirely avoids this partial market breakdown phenomenon. We find 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, it reduces the ability of strategic liquidity suppliers to exclude them from trade to better extract rents from agents with lower cash-flows. We also show that competition in non-exclusive schedules between finitely many oligopolistic liquidity suppliers implements the competitive trading mechanism.

Keywords: Security design, liquidity, mechanism design, adverse selection

JEL Classification: G32, L14