AbstractThe paper revisits and qualifies existing insights on security design. A rich literature
argues that tranching creates debt-like instruments that are robust to adverse
selection or discourage wasteful information acquisition. Yet, for a given information
structure, while tranching confines and liquefies the safe part of a cash flow (the insulation
effect), bundling makes the risky part more liquid (the trading adjuvant effect).
Moreover, tranching always has adverse welfare effects on information acquisition:
It encourages (discourages) information acquisition when it should be deterred (encouraged).
The paper provides conditions under which tranching reduces welfare
even when the insulation effect dominates the trading adjuvant effect. The paper’s
second contribution is to analyze the velocity of assets that are repeatedly traded. The
dynamic model can be nested into the static one and insights are shown to be closely
related to those on tranching. The central insight is that liquidity is self-fulfilling: A
perception of future illiquidity creates current illiquidity