A Model of Financial Market Control

TL;DR

This paper models financial market manipulation and demonstrates how strategic control interventions can prevent manipulation, expanding the set of manipulation-proof pricing rules in a linear system.

Contribution

It introduces a control framework that prevents market manipulation in a linear price-impact model, showing how intervention enlarges manipulation-proof rule sets.

Findings

A control strategy can prevent market manipulation as an equilibrium outcome.

Without control, manipulation-proof rules are very restrictive.

Control significantly expands the set of manipulation-proof linear pricing rules.

Abstract

This study investigates the prevention of market manipulation using a price-impact model of financial market trading as a linear system. First, I define a trading game between speculators such that they implement a manipulation trading strategy that exploits momentum traders. Second, I identify market intervention by a controller (e.g., a central bank) with a control of the system. The main result shows that there is a control strategy that prevents market manipulation as a subgame perfect equilibrium outcome of the trading game. On the equilibrium path, no intervention is realized. This study also characterizes the set of manipulation-proof linear pricing rules of the system. The set is very restrictive if there is no control, while the presence of control drastically expands the set.