Security design without verifiable retention

Abstract

This paper studies security design with adverse selection when verifiable retention is impossible due to market segmentation and price opacity across market segments. Rather than signaling through retention, sellers in the model signal quality through posted prices, which is feasible because the posted price affects buyers' search behavior and the equilibrium probability of selling. The optimal security design, in this case, is to break up the cash flow of an asset into several debt securities of increasing seniority. The size of senior relative to subordinated debts is affected by the equilibrium markup. Search frictions, as determinants of the markup, shape the endogenous creation of financial securities.