Opacity in security design: The role of post-issuance derivative trading

We analyze the role of post-issuance derivative markets in providing incentives to design opaque securities using a Bayesian persuasion framework. While opacity potentially hurts the originator in the primary market by generating adverse selection, an opaque security allows the originator to profit from informed speculation in derivatives. The originator typically confronts this trade off by choosing an intermediate level of opacity. The more liquid the derivative market, the higher the expected profits from post-issuance speculation and thus the higher the equilibrium level of opacity. Opacity is also more attractive when adverse macro shocks tend to be rare. Our model is consistent with anecdotal evidence on the behavior of originators before the financial crisis as well as with the observed increase in popularity of opaque securities at a time of major explosion in derivative trading. Finally, it has implications for the current debate about a potential repeal of the Volcker rule.