"Trading and Information Diffusion in Over-the-Counter Markets" (with Peter Kondor).
Econometrica, vol. 86, 1727-1769, 2018.
[Abstract] [Paper] [Online Appendices] [MATLAB code][Link to article] [Note on the Equilibrium]
We propose a model of trade in OTC markets in which each dealer with private information can engage in bilateral transactions with other dealers, determined by her links in a network. Each dealer's strategy is represented as a quantity-price schedule. We analyze the effect of trade decentralization and adverse selection on information diffusion, expected profits, trading costs and welfare. Information diffusion through prices is not affected by dealers' strategic trading motives, and there is an informational externality constraining the informativeness of prices. Trade decentralization can both increase or decrease welfare. The main determinant of a dealer's trading cost is the centrality of her counterparties. Central dealers tend to learn more, trade more at lower costs and earn higher expected profit.
We provide a theory of trading through intermediaries in OTC markets. The role of intermediaries is to sustain trade, when trade is beneficial. In our model, traders are connected through a network. Agents observe their neighbors' actions, and can trade with their counterparty in a given period through a path of intermediaries in the network. However, agents can renege on their obligations. We show that trading through a network is essential to support trade, when agents infrequently meet the same counteparty in the market. However, intermediaries must receive fees to have the incentive to implement trades. Concentrated intermediation, as represented by a star network, is both a constrained efficient and a stable structure, when agents incur linking costs. Moreover, the center agent in a star can receive higher fees as well.
Modern banking systems are highly interconnected. Despite their various benefits, linkages between banks carry the risk of contagion. In this paper we investigate whether banks can commit ex-ante to mutually insure each other, when there is contagion risk in the financial system. Banks can share the risk through bilateral agreements, and we model their decisions as a network formation game. A financial network that allows losses to be shared among various counterparties emerges endogenously. We show that in an equilibrium network the degree of systemic risk, defined as the probability that contagion occurs conditional on one bank failing, is significantly reduced. In certain equilibria, contagion does not occur.
We develop a model in which asset commonality and short-term debt of banks interact to generate excessive systemic risk. Banks swap assets to diversify their individual risk. Two asset structures arise. In a clustered structure, groups of banks hold common asset portfolios and default together. In an unclustered structure, defaults are more dispersed. Portfolio quality of individual banks is opaque but can be inferred by creditors from aggregate signals about bank solvency. When bank debt is short-term, creditors do not roll over in response to adverse signals and all banks are inefficiently liquidated. This information contagion is more likely under clustered asset structures. In contrast, when bank debt is long-term, welfare is the same under both asset structures.
"Global Stochastic Properties of Dynamic Models and their Approximations" (with Casper de Vries).
Journal of Economic Dynamics and Control, vol. 34, 817-824, 2010.
[Abstract] [Paper] [Link to article]
The dynamic properties of micro based stochastic macro models are often analyzed through a linearization around the associated deterministic steady state. Recent literature has investigated the error made by such a deterministic approximation. Complementary to this literature we investigate how the linearization affects the stochastic properties of the original model. We consider a simple real business cycle model with noisy learning by doing. The solution has a stationary distribution that exhibits moment failure and has an unbounded support. The linear approximation, however, yields a stationary distribution with possibly a bounded support and all moments finite.
We study the determinants of asset market fragmentation in a model with strategic investors that disagree about the value of an asset. Investors choices determine the market structure. Fragmented markets are supported in equilibrium when disagreement between investors is low. In this case, investors take the same side of the market and are willing to trade in smaller markets with a higher price impact to face less competition when trading against a dealer. The maximum degree of market fragmentation increases as investors' priors are more correlated. Dealers can benefit from fragmentation, but investors are always better off in centralized markets.
We propose a model where both security design and market structure are endogenously determined to explain why standardized securities are frequently traded in decentralized markets. We find that issuers offer debt contracts in thinner markets where investors have a higher price impact, and equity in deeper markets. In turn, investors accept to trade in thinner markets to elicit less variable securities from issuers if gains from trade are small. Otherwise, investors choose to trade in deeper markets where their price impact is minimized. We also show that there exist equilibrium market structures in which both debt and equity are traded.
We explore a model in which banks strategically hold interconnected and opaque portfolios, despite increasing the likelihood they are subject to financial crises. In our framework, banks choose their degree of exposure to other banks to influence how investors can use their information. In equilibrium banks choose portfolios which are neither fully opaque, nor fully transparent. However, their portfolios are interconnected beyond what is beneficial for diversification purposes. Banks can create a degree of opacity that decreases welfare, and makes bank crises more likely. Our model is suggestive about the implications of asset securitization, as well as of government bailouts.
Financial crises have occurred for many centuries. They are often preceded by a credit boom and a rise in real estate and other asset prices as in the current crisis. They are also often associated with severe disruption in the real economy. This paper surveys the theoretical and empirical literature on crises. The first explanation of banking crises is that they are a panic. The second is that they are part of the business cycle. Modeling crises as a global game allows the two to be unified. With all the liquidity problems in interbank markets that have occurred during the current crisis, there is a growing literature on this topic. Perhaps the most serious market failure associated with crises is contagion and there are many papers on this important topic. The relationship between asset price bubbles, particularly in real estate, and crises is discussed at length.
Modern financial systems exhibit a high degree of interdependence. There are different possible sources of connections between financial institutions, stemming from both the asset and the liability side of their balance sheet. For instance, banks are directly connected through mutual exposures acquired on the interbank market. Likewise, holding similar portfolios or sharing the same mass of depositors creates indirect linkages between financial institutions. Broadly understood as a collection of nodes and links between nodes, networks can be a useful representation of financial systems. By providing means to model the specifics of economic interactions, network analysis can better explain certain economic phenomena. In this paper we argue that the use of network theories can enrich our understanding of financial systems. We review the recent developments in financial networks, highlighting the synergies created from applying network theory to answer financial questions. Further, we propose several directions of research. First, we consider the issue of systemic risk. In this context, two questions arise: how resilient financial networks are to contagion, and how financial institutions form connections when exposed to the risk of contagion. The second issue we consider is how network theory can be used to explain freezes in the interbank market of the type we have observed in August 2007 and subsequently. The third issue is how social networks can improve investment decisions and corporate governance. Recent empirical work has provided some interesting results in this regard. The fourth issue concerns the role of networks in distributing primary issues of securities as, for example, in initial public offerings, or seasoned debt and equity issues. Finally, we consider the role of networks as a form of mutual monitoring as in microfinance.