Opacity and the Optimality of Debt for Liquidity Provision

Abstract

Asymmetric information can reduce trade (possibly to zero) due to adverse selection. Symmetric information can facilitate trade. We show that trade between agents is maximized, and welfare highest, when neither party to a transaction has any information about the future payoffs of the securities used to trade. Trade is best implemented by debt which preserves ignorance because it provides the smallest incentive for private information production, which creates adverse selection. Debt’s value is also least sensitive to public signals. In this economy policies that increase transparency would reduce welfare. Finally, even if there is adverse selection in the market, debt maximizes the amount of trade. For the economy as a whole there is a systemic risk of using debt to provide liquidity: an aggregate shock, if bad enough, can be made worse by triggering private information production, causing adverse selection when debt becomes information-sensitive.