Working Paper: CEPR ID: DP15861
Authors: Ana Babus; Kinda Hachem
Abstract: The vast majority of regulatory debates about the benefits of centralized trading assume that the set of securities designed by financial intermediaries is immune to the market structure in which trade occurs. In this paper, we consider a regulator who redesigns the market structure for certain financial contracts by introducing an exchange to increase liquidity, understanding that security design is endogenous. For a given market structure, investors would like to trade a less risky security and, for a given security, they would like to trade in a larger market. We show that the security that intermediaries design after the introduction of the exchange is of lower quality, in the sense of a lower expected payoff per unit of standard deviation. This reflects the relative dilution of investor market power, as investors have zero price impact on the exchange and hence less influence on intermediary security design. The issuance of lower quality securities to investors arises even when the introduction of the exchange leads intermediaries to originate better underlying assets. With a large enough exchange, the decline in the quality of the security is so severe that investors can be worse off as a result of the introduction of the exchange. We then consider how origination subsidies could be used by the regulator to counter the negative effects of introducing the exchange on security design.
Keywords: security design; market structure; market power
JEL Codes: D47; D86; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| introduction of an exchange (Y20) | decrease in investor market power (G19) |
| decrease in investor market power (G19) | lower quality securities (G12) |
| introduction of an exchange (Y20) | lower quality securities (G12) |
| regulatory intervention (G18) | improve security design (F52) |