Regulation and security design in concentrated markets

•An exchange is introduced to increase the liquidity of financial contracts.•Investors' relative market power falls and intermediaries design riskier securities.•The securities are riskier even though the underlying assets are safer.•Investors are worse off if the exchange is sufficiently large.•Need coordinated policies to enhance market liquidity and control security design. Regulatory debates about centralized trading assume security design is immune to market structure. We consider a regulator who introduces an exchange to increase liquidity, understanding that security design is endogenous. For a given security, investors would like to trade in a larger market and, for a given market structure, they would like to trade a safer security. We show that financial intermediaries design riskier securities after the exchange is introduced, even when the exchange leads to the origination of safer underlying assets. The results reflect a relative dilution of investor market power and motivate coordinated policies to improve investor welfare.