Arbitrage Networks

Abstract

This paper studies the general equilibrium implications of arbitrage trades in segmented financial markets. Arbitrageurs choose a category of trades to specialize in. This results in an equilibrium network in which the various market segments are linked by arbitrageurs. Arbitrageurs exert externalities on each other depending on their position in the network. Due to these externalities, the complete network architecture, in which all links are feasible, is in general suboptimal for arbitrageurs; it is dominated by a hub-spoke architecture. The hub acts as a repository of liquidity, facilitating trades with minimal price impact. For an arbitrary architecture, as the mass of arbitrageurs grows, equilibrium prices converge to those of the frictionless economy with no segmentation. On the other hand, even if the architecture is complete, equilibrium networks may not be complete or even connected, regardless of the mass of arbitrageurs.

Keywords: Arbitrage, segmented markets, networks, externalities

JEL Classification: D53, D85