Spiraling Toward Complete Markets and Financial Instability

author: Matteo Marsili, ICTP - The Abdus Salam International Centre for Theoretical Physics
published: July 10, 2009,   recorded: June 2009,   views: 4118

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The proliferation of financial instruments provides more opportunities to hedge risks, reducing transaction costs and making markets more complete. These predictions sharply contrasts with recent experience, where asymmetric information and imperfect competition have played a major role in turning expanding credit derivative markets into ”financial weapons of mass destruction”. Here I argue that the escalation of market imperfections originates from the changes which take place in the nature of the market equilibria, when the repertoire of financial instruments expands. This is done in the limit of a large random economy, where a set of consumers invests in financial instruments engineered by banks, in order to optimize their future consumption. I show that, even in the ideal case of perfect competition, where full information is available to all market participants, as markets approach completeness and transaction costs vanish, the equilibrium develops a marked vulnerability (or susceptibility) to market imperfections. Therefore, the onset of instability does not require large shocks, but it rather arises from the intrinsic nature of the equilibrium. One particularly devastating effect is that, replicating portfolios used by banks to hedge new instruments, require trading volumes, within the financial sector, which diverge as the market approaches completeness. Such interbank market itself develops a divergent susceptibility, as the theoretical limit of complete markets is approached. A similar approach shows that the expansion of derivative markets generates instability and large movements in underlying markets. These results suggest that the proliferation of financial instruments exacerbates the effects of market imperfections. In order to prevent an escalation of perverse effects, markets may necessitate institutional structures which are more and more conspicuous as they expand.

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