Financial Product Design in Decentralized Markets

Abstract

Decentralized trading motivates financial innovation that would be neutral if assets cleared jointly: Synthetic products, such as derivatives, are generally nonredundant. In markets with large traders, synthetic products alter the price impact for the underlying assets and, when appropriately designed, enhance risk sharing and diversification. While mutual funds are efficient in decentralized markets with competitive investors, they generally are not when traders are large. Instead, a limited number of synthetic products tailored to traders’ desired risk profile strictly increase welfare under general conditions. The efficient set of securities differs from the underlying assets. It facilitates trading of all fundamental risks but generally forgoes hedging all contingencies in response to price impact.

Keywords: Imperfect competition, Decentralized market, Security design, Market design, Liquidity, Price impact, Efficiency

JEL Classification: D47, D53, D82, G11, G12