Design of Synthetic Financial Products in Decentralized Markets
63 Pages Posted: 14 Jul 2020 Last revised: 3 Jan 2022
Date Written: December 31, 2021
Decentralized trading motivates financial innovation that would be neutral if assets cleared jointly: Derivatives are generally nonredundant. In markets with large traders, derivatives alter price impact for the underlying assets and, when suitably designed, improve risk sharing and diversification. While mutual funds are efficient in competitive markets, imperfect competition qualifies their efficiency with decentralized trading. Instead, a limited number of synthetic products tailored to traders' desired risk profile strictly increase welfare under general conditions. The efficient set of securities allows trading all fundamental risks but generally forgoes hedging all contingencies in response to price impact.
Keywords: Imperfect competition, Market design, Decentralized market, Security design, Innovation, Liquidity, Price impact, Uniform-price auction, Efficiency
JEL Classification: D47, D53, G11, G12
Suggested Citation: Suggested Citation