Markets for Financial Innovation
66 Pages Posted: 23 Jan 2019 Last revised: 11 Feb 2021
Date Written: January 2019
Financial securities trade in a wide variety of market structures. This paper develops a theory in which both the market structure of trade and the payoffs of the claims being traded form endogenously. Financial intermediaries use the cash flows of an underlying asset to design securities for investors. The demand for securities arises as investors choose markets then trade using strategies represented by quantity-price schedules. We find that intermediaries create increasingly riskier securities when facing deeper markets in which investors trade more competitively. In turn, investors elicit safer securities when they choose to trade in thinner, more fragmented markets. These findings reveal a novel role for market fragmentation in the creation of safer securities. The model is also informative about which investor classes trade which securities and how the distributional properties of the underlying asset affect the relationship between security design and market structure.
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