DP13069 Dynamic Liquidity-Based Security Design

Author(s): Emre Ozdenoren, Kathy Yuan, Shengxing Zhang
Publication Date: July 2018
Keyword(s): financial fragility, liquidity, repo, security design
JEL(s): G01, G10
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13069

Abstract We study a dynamic problem of the design and sale of a security backed by a long-lived asset. The dividend payment on the asset may be high or low. Issuers are privately informed about the quality of the asset, and raise capital by securitizing part of it to fund a productive technology. Issuers can pledge not only the current period payoff from the assets, but also the future resale price. There is a dynamic feedback loop between the future asset price and today's issuers' decision where both adverse selection and the productivity level determine the liquidity of the security. Multiple dynamic - liquid and illiquid - equilibria might arise when only equity contracts can be issued. We characterize the optimal security design and demonstrate short-term liquid collateralized debt, or short-term repo, is optimal and eliminates the multiple equilibria fragility. In fact, the unique equilibrium under debt contract improves social welfare relative to the illiquid equity equilibrium.