Spiraling toward market completeness and financial instability

TL;DR

This paper analyzes how increasing financial instruments in large economies can lead to market vulnerabilities and instability, even under perfect competition, due to diverging trading volumes and systemic risks.

Contribution

It reveals that market completeness and the proliferation of financial instruments can induce systemic vulnerabilities, highlighting the need for new theories and institutional safeguards.

Findings

Market completeness increases vulnerability to imperfections.

Trading volumes diverge as markets approach completeness.

Financial instrument proliferation exacerbates systemic risks.

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.