Financial Product Design in Decentralized Markets
44 Pages Posted: 14 Jul 2020 Last revised: 13 Feb 2024
Date Written: February 11, 2024
Abstract
Decentralized trading motivates financial innovation, making synthetic products like derivatives nonredundant, even when all traders trade all assets. This nonredundancy arises because derivatives affect cross-security inference (information) and, in markets with large traders, equilibrium price impact (liquidity). The efficient securities differ from the underlying assets. While the market index/mutual funds are efficient in decentralized markets with competitive investors, heterogeneous portfolios that balance index tracking with liquidity transformation become efficient in markets with large traders. Efficient securities facilitate the trading of all fundamental risks but generally forgo hedging all contingencies to minimize the price impact costs associated with risk sharing and diversification.
Keywords: Imperfect competition, Decentralized market, Security design, Market design, Liquidity, Price impact, Efficiency
JEL Classification: D47, D53, D82, G11, G12
Suggested Citation: Suggested Citation