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Spiraling toward market completeness and financial instability

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  • Matteo Marsili

Abstract

I study the limit of a large random economy, where a set of consumers invests in financial instruments engineered by banks, in order to optimize their future consumption. This exercise shows that, even in the ideal case of perfect competition, where full information is available to all market participants, the equilibrium develops a marked vulnerability (or susceptibility) to market imperfections, as markets approach completeness and transaction costs vanish. The decrease in transaction costs arises because financial institutions exploit trading instruments to hedge other instruments. This entails trading volumes in the interbank market which diverge in the limit of complete markets. These results suggest that the proliferation of financial instruments exacerbates the effects of market imperfections, calling for theories of market as interacting systems. From a different perspective, in order to prevent an escalation of perverse effects, markets may necessitate institutional structures which are more and more conspicuous as their complexity expands.

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  • Matteo Marsili, 2009. "Spiraling toward market completeness and financial instability," Papers 0906.1462, arXiv.org.
  • Handle: RePEc:arx:papers:0906.1462
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    1. Robert Jarrow, 2017. "Credit Risk," World Scientific Book Chapters, in: THE ECONOMIC FOUNDATIONS OF RISK MANAGEMENT Theory, Practice, and Applications, chapter 6, pages 53-58, World Scientific Publishing Co. Pte. Ltd..
    2. HyunSong Shin, 2009. "Securitisation and Financial Stability," Economic Journal, Royal Economic Society, vol. 119(536), pages 309-332, March.
    3. Hyun Song Shin, 2009. "Securitisation and Financial Stability," Economic Journal, Royal Economic Society, vol. 119(536), pages 309-332, March.
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