Dynamic Liquidity-based Security Design

We study a dynamic problem of the design and sale of a security backed by a productive asset. The return on the asset may be high or low. The issuers are privately informed about the quality of the asset, and raise capital by securitizing part of it. Issuers can pledge not only the current period payoff from the assets, but also the future re-sell prices which depends on inter-temporal coordination. Both adverse selection and inter-temporal coordination determine the liquidity of the security. We show that when only equity contracts can be issued, multiple dynamic - liquid and illiquid - equilibria might arise. We further characterize the optimal security design and demonstrate standard liquid debt 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.

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