Eroding market stability by proliferation of financial instruments

TL;DR

This paper challenges the assumption that more financial instruments always enhance market stability, showing instead that proliferation can lead to systemic instability and critical market states.

Contribution

It provides a dynamical model contrasting traditional arbitrage theory with market interactions, revealing how proliferation of derivatives can erode stability.

Findings

Proliferation of financial instruments increases market susceptibility.

Market fluctuations and correlations are amplified by instrument proliferation.

Stability may require regulatory measures in derivative markets.

Abstract

We contrast Arbitrage Pricing Theory (APT), the theoretical basis for the development of financial instruments, with a dynamical picture of an interacting market, in a simple setting. The proliferation of financial instruments apparently provides more means for risk diversification, making the market more efficient and complete. In the simple market of interacting traders discussed here, the proliferation of financial instruments erodes systemic stability and it drives the market to a critical state characterized by large susceptibility, strong fluctuations and enhanced correlations among risks. This suggests that the hypothesis of APT may not be compatible with a stable market dynamics. In this perspective, market stability acquires the properties of a common good, which suggests that appropriate measures should be introduced in derivative markets, to preserve stability.