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Markets for financial innovation

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  • Babus, Ana
  • Hachem, Kinda

Abstract

We develop a theory of financial innovation in which both market structure and the payoffs of the claims being traded are determined endogenously. Intermediaries use the cash flows of an underlying asset to design securities for investors. Demand for securities arises as investors choose markets then trade using strategies represented by quantity-price schedules. We show that intermediaries create increasingly riskier asset-backed securities when facing deeper markets in which investors trade more competitively. In turn, investors elicit less risky securities when they choose thinner markets, revealing a novel role for market fragmentation in the creation of safer securities.

Suggested Citation

  • Babus, Ana & Hachem, Kinda, 2023. "Markets for financial innovation," Journal of Economic Theory, Elsevier, vol. 208(C).
    • Handle: RePEc:eee:jetheo:v:208:y:2023:i:c:s002205312300011x
    DOI: 10.1016/j.jet.2023.105615
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    Cited by:

    1. Jérôme Dugast & Semih Üslü & Pierre-Olivier Weill, 2022. "A Theory of Participation in OTC and Centralized Markets," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 89(6), pages 3223-3266.
    2. Thomas M. Eisenbach & Gregory Phelan, 2022. "Cournot Fire Sales," American Economic Journal: Macroeconomics, American Economic Association, vol. 14(3), pages 508-542, July.
    3. Jiaji An & He Di, 2024. "How Can Financial Innovation Curb Carbon Emissions in China? Exploring the Mediating Role of Industrial Structure Upgrading from a Spatial Perspective," Sustainability, MDPI, vol. 16(11), pages 1-20, May.

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    More about this item

    Keywords

    Security design; Market structure; Market power;
    All these keywords.

    JEL classification:

    • D47 - Microeconomics - - Market Structure, Pricing, and Design - - - Market Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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