A Side Effect of Financial Innovation

106 Pages Posted: 27 May 2020

See all articles by Veronika Selezneva

Veronika Selezneva

Charles University in Prague - CERGE-EI (Center for Economic Research and Graduate Education - Economics Institute)

Date Written: December 27, 2015

Abstract

Financial innovation often involves the creation of new instruments that bundle existing securities such as mutual funds or exchange traded funds. In this paper we argue that while the creation of such assets has advantages such as lowering transaction costs, there can also be negative side effects. Investment in the new instrument may reveal information about future demand for the underlying securities, as the fund managing the instrument often needs to mechanically re-balance its position. Informed arbitrageurs may trade, exploiting their knowledge of this re-balancing. In general equilibrium, this trading activity can make the price of the underlying securities less informative and more sensitive to re-balancing shocks. We show that this loss of information may outweigh the direct gains from lower transaction costs that uninformed investors achieve. So welfare of uninformed investors may be lower. We argue that the potential effect on the market for the underlying securities may be substantial. To illustrate our mechanism, we analyze two episodes of financial innovations in the oil and volatility markets. The magnitude of the effect can be gauged by the fact that introduction of the new instrument in the oil market led to a temporary violation of a no-physical arbitrage condition.

Keywords: USO, Oil Market, Term Structure, Futures Prices, ETF

JEL Classification: G12, G14

Suggested Citation

Selezneva, Veronika, A Side Effect of Financial Innovation (December 27, 2015). Available at SSRN: https://ssrn.com/abstract=3588350 or http://dx.doi.org/10.2139/ssrn.3588350

Veronika Selezneva (Contact Author)

Charles University in Prague - CERGE-EI (Center for Economic Research and Graduate Education - Economics Institute) ( email )

P.O. Box 882
7 Politickych veznu
Prague 1, 111 21
Czech Republic

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