Design of Synthetic Financial Products in Decentralized Markets
40 Pages Posted: 14 Jul 2020 Last revised: 4 May 2021
Date Written: May 3, 2021
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: Suggested Citation