Community Research and Development Information Service - CORDIS


FRICTIONS Report Summary

Project ID: 336585
Funded under: FP7-IDEAS-ERC
Country: United Kingdom

Mid-Term Report Summary - FRICTIONS (Frictions in the Financial System)

The financial crisis, since its start in 2008 has exposed enormous fractures both in the financial architecture and in the structure of the global economy. Although with some notable exceptions, the magnitude of the events caught the finance profession largely by surprise. The main objective of my project is to understand better the institutional mechanism channeling savings towards the best uses of capital, and to what extent this mechanism can sometimes fail.
I have suggested a dual approach to push the boundaries of our knowledge in this area. First, we improve our understanding of which frictions are the crucial impediments of the efficient functioning of markets. As this approach focuses on particular markets in isolation, I call this the micro approach. I am working on four projects within this approach: (1) trading and information diffusion in OTC markets, (2) learning in crowded markets, (3) financial innovation with cursed investors, and (4) the dynamics of sovereign bond spreads and the real economy.
I made significant achievements in each of these projects in the covered period as summarized below.

a-I.1 Trading and information diffusion in OTC markets (with Ana Babus)
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.

a-I.2. Learning in Crowded Markets (with Adam Zawadowski)
We study how competition among investors affects the efficiency of capital allocation, the speed of capital, and welfare. In our model, investors learn about other entrants in a fully flexible way. We find that competition increases the speed of capital, but does not necessarily improve the efficiency of capital allocation: there is persistent over- or underinvestment. As speed is a by-product of costly over-learning, increasing competition decreases welfare. We describe how the speed of capital and the level of over- or underinvestment depend on market and investor characteristics. With investors of heterogeneous skills, more sophisticated investors might harm welfare.

a-I.3. Dynamics of Sovereign Bond Spreads and the Real Economy (with Maryam Farboodi)
We build a model where countries differ in reputation. Countries with better reputation are perceived as fundamentally healthy by more investors, even when they are not, and countries with lower reputation are perceived as fundamentally unhealthy by more investors, even if they are fundamentally healthy. We show that in this economy, pessimism shocks can move the economy from a boom period where bonds spreads are the same for all, to recession periods where the bond spreads are very low for high reputation countries, but very high for low reputation countries. As these future states are foreseen, it creates heterogeneous investment ex-ante and heterogeneous growth ex-post across these countries , even if ex-ante these countries are fundamentally identical.

a-I.4. Cursed Financial Innovation (with Botond Koszegi)
We analyze the welfare properties of derivative securities that profit-maximizing issuers offer to investors who have inferior information and neglect the information content of the offer. To capture the markets for structured securities and exotic exchange-traded funds, we assume that issuers can choose both the underlying asset and the form of the security. An issuer's optimal security induces investors to bet on unlikely market movements, creating both excess risk taking and undersaving. Giving more information to the issuer leads it to choose an underlying asset on which its information is more extreme, exacerbating both effects and hence lowering social welfare. Furthermore, providing inferior and noisy additional information to investors also lowers welfare because the security is then written on an underlying asset about which the information is misleading. If the issuer can base its security on a combination of underlying assets, it optimally creates a ``custom-designed'' index to maximize its informational advantage and minimize risk, minimizing investor and social welfare. Restricting the set of underlying assets---a kind of standardization---increases welfare by preventing the issuer from systematically selling a security with extreme or misleading information. Once this policy is adopted, increasing investor information becomes beneficial.

Second, from the frictions emerging from the micro approach, we have to select the ones which determine the aggregate liquidity fluctuations in the economy. I use this concept in a broad sense; referring to the changing efficiency with which the financial system allocates resources across investment opportunities. As this approach focuses on the functionality of the financial system as a whole, I call this the macro approach. I propose two projects within this approach. The first project focuses on the determinants of the differences in the financial architecture of different economies. It builds a novel framework to study the dynamics of the financial sector of an economy. The second project studies the role of shadow banking in the fluctuation of aggregate liquidity. In particular, this project concentrates on the fluctuation of the efficiency of private liquidity creation as the state of the economy changes.

Out of the two projects, I made significant progress in the first one in the covered period.
a-II-1 Liquidity Risk and the Dynamics of Arbitrage Capital (with Dimitri Vayanos)
We develop a dynamic model of liquidity provision, in which hedgers can trade multiple risky assets with arbitrageurs. We compute the equilibrium in closed form when arbitrageurs' utility over consumption is logarithmic or risk-neutral with a non-negativity constraint. Arbitrageurs increase their positions following high asset returns, and can choose to provide less insurance when hedgers are more risk-averse. The stationary distribution of arbitrageur wealth is bimodal when hedging needs are strong. Liquidity is increasing in arbitrageur wealth, while asset volatilities, correlations, and expected returns are hump-shaped. Assets that suffer the most when aggregate liquidity decreases offer the highest expected returns. This is because the arbitrageurs' portfolio is a pricing factor, and aggregate liquidity captures exactly that factor.

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United Kingdom
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