Design of Synthetic Financial Products in Decentralized Markets

40 Pages Posted: 14 Jul 2020 Last revised: 4 May 2021

See all articles by Marzena J. Rostek

Marzena J. Rostek

University of Wisconsin - Madison

Ji Hee Yoon

University College London - Department of Economics

Date Written: May 3, 2021

Abstract

We examine the design of synthetic financial products in decentralized markets, which clear independently across securities. Derivatives are generally nonredundant even with zero net supply. Such synthetic products for spanned risks can change information in traders' demands and traders' price impact for the underlying assets. For any underlying assets, suitably designed synthetic products can strictly increase welfare under general conditions. This result applies to markets in which the underlying assets may or may not be traded. Given the securities traded, innovating securities for unspanned fundamental risk in traders' asset holding may harm welfare. When traders have price impact, the efficient set of securities allows trading all fundamental risks but generally limits the cross-asset information on which traders' demands can condition. Our results underscore the role of imperfect competition for design of synthetic products. Decentralized trading motivates the design of financial innovation that is based on spanning, as well as innovation that is not.

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

Rostek, Marzena J. and Yoon, Ji Hee, Design of Synthetic Financial Products in Decentralized Markets (May 3, 2021). Available at SSRN: https://ssrn.com/abstract=3631479 or http://dx.doi.org/10.2139/ssrn.3631479

Marzena J. Rostek

University of Wisconsin - Madison ( email )

1180 Observatory Drive
Madison, WI 53703
United States
(608) 262-6723 (Phone)
(608) 262-2033 (Fax)

HOME PAGE: http://www.ssc.wisc.edu/~mrostek

Ji Hee Yoon (Contact Author)

University College London - Department of Economics ( email )

Drayton House, 30 Gordon Street
30 Gordon Street
London, WC1H 0AX
United Kingdom

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