Equilibrium security design and liquidity creation by privately informed issuers

OMI Seminar Series

By supplying riskless claims ("liquidity") an issuer can insulate uninformed investors from adverse selection in competitive securities markets. We evaluate private incentives to supply riskless securities, analyzing equilibrium security design by a privately informed issuer selling asset-backed claims in competitive markets to an endogenously informed speculator and rational uninformed investors who demand liquidity. First-best social welfare is attained if pooling occurs at the low type's preferred structuring in which the full asset is securitized as riskless debt and levered equity. However, this structuring is not generally an equilibrium. There always exists an equilibrium in which the issuer sells riskless debt and retains all risk. However, this equilibrium fails to be unique precisely when uninformed investors have high liquidity demand. Specifically, when uninformed investors have high liquidity demand, pooling may occur at the preferred structure of the high type who maximizes informed trading by intead selling risky debt, with optimal information-sensitivity trading off per-unit speculator gains against endogenous declines in uninformed demand. The model thus shows the private supply of riskless debt can fall precisely when investors most value liquidity. However, a government supplying relatively small amounts of riskless debt potentially ensures sufficient aggregate liquidity. This is because, as is shown, public and private liquidity are strategic complements. Specifically, by siphoning-off uninformed demand for risky securities, public liquidity crowds-out informed speculation, and crowds-in private liquidity.

Joint paper with Chris Hennessy (LBS).


Gilles Chemla (Imperial)

Tuesday, November 27, 2012 - 12:30
to 13:30