Opacity and Liquidity

We present a model that links the opacity of an asset to its liquidity. While low opacity assets are liquid, intermediate levels of opacity provide incentives for investors to acquire private information, causing adverse selection and illiquidity. High opacity, however, benefits liquidity by reducing the value of a unit of private information to investors. The cross-section of bid-ask spreads of U.S. firms is shown to be consistent with this hump-shape relationship between opacity and illiquidity. A key policy implication of the analysis is that uniform disclosure requirements may not be desirable. Optimal information production can instead be achieved by subsidizing the provision of information by asset originators. Our model of opacity and liquidity can also be used to understand the incentives of originators to sell intransparent products as well as to enhance correlation within a pool of assets.