Citation

Discussion Paper Details

Please find the details for DP8336 in an easy to copy and paste format below:

Full Details   |   Bibliographic Reference

Full Details

Title: Security Design: Signaling versus Speculative Markets

Author(s): Gilles Chemla and Christopher Hennessy

Publication Date: April 2011

Keyword(s): issuer, pooling, security design, separating, speculator and type

Programme Area(s): Financial Economics

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.

For full details and related downloads, please visit: https://cepr.org/active/publications/discussion_papers/dp.php?dpno=8336

Bibliographic Reference

Chemla, G and Hennessy, C. 2011. 'Security Design: Signaling versus Speculative Markets'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=8336