We study how securities and issuance mechanisms can be designed to mitigate the adverse impact of market imperfections on liquidity. In our model, asset owners seek to obtain liquidity by selling claims contingent on privately observed future cash-flows. Liquidity suppliers can be competitive or strategic. In the optimal trading mechanism associated with an arbitrary given security, issuers with low cash-flows sell their entire holdings of the security, while issuers with high cash-flows are typically excluded from trade. By designing the security optimally, issuers can avoid exclusion altogether. We show that the optimal security is debt. Because of its low informational sensitivity, debt mitigates the adverse selection problem. Furthermore, by pooling all issuers with high cash-flows, debt also reduces the ability of a monopolistic liquidity supplier to exclude them from trade in order to better extract rents from issuers with lower cash-flows.

We measure the degree of overconfidence in judgement (in the form of miscalibration, i.e. the tendency to overestimate the precision of one's information) and self-monitoring (a form of attentiveness to social cues) of 245 participants and also observe their behaviour in an experimental financial market under asymmetric information. Miscalibrated traders, underestimating the conditional uncertainty about the asset value, are expected to be especially vulnerable to the winner's curse. High self-monitors are expected to behave strategically and achieve superior results. Our empirical results show that miscalibration reduces and self-monitoring enhances trading performance. The effect of the psychological variables is strong for men but non-existent for women. Copyright 2005, Wiley-Blackwell.