The aim of this paper is to identify an optimal contract design for
institutions bilaterally exchanging liquidity on a decentralized asset market with
Lucas (1978) trees subject to asymmetric information. Within a search-theoretic
dynamic general equilibrium model à la Lagos and Wright (2005), I establish a
non-equivalence between collateralized credit and immediate settlement (an outright
sale of assets) and show through a signaling game with Perfect Bayesian Nash
Equilibra, why depositing assets as collateral is a dominant strategy. In addition, I
provide a compelling reason why financial institutions apply haircuts to securities
offered as collateral (over-collateralization), which justifies the observed behavior on
the over-the-counter market for liquidity since the eruption of the global financial
crisis.
The aim of the first paper is to identify an optimal contract design for institutions bilaterally exchanging liquidity on a decentralized asset market with Lucas (1978) trees subject to asymmetric information. Within a search-theoretic dynamic general equilibrium model à la Lagos and Wright (2005), I establish a non-equivalence between collateralized credit and immediate settlement (an outright sale of assets) and show through a signaling game with Perfect Bayesian Nash Equilibra, why depositing assets as collateral is a dominant strategy. In addition, I provide a compelling reason why financial institutions apply haircuts to securities offered as collateral (over-collateralization), which justifies the observed behavior on the over-the-counter market for liquidity since the eruption of the global financial crisis.
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