A market-based solution to price externalities

Robert Townsend, Weerachart Kilenthong

In the aftermath of the Global Crisis, models with pecuniary externalities have gained popularity. This column presents a new framework that encompasses many of these externalities. The authors also show how to design financial contracts and markets in such a way that ex ante competition can achieve a constrained-efficient allocation.

In the aftermath of the recent Global Crisis, models with pecuniary externalities have regained the interest of researchers as they seek policy interventions and regulations to remedy externality-induced distortions. There is a growing literature on fire sales and amplifiers where private agents undervalue net worth in a period of financial distress because they fail to internalise that net worth has positive spillovers on other agents.

Various models of the recent Crisis with externalities

For example, Bianchi and Mendoza (2012) study the relationship of these so-called credit externalities to financial fragility and welfare losses from balance sheet effects. There is a much larger literature in the international context, e.g., Caballero and Krishnamurthy (2001) and Jeanne and Korinek (2010). Lorenzoni (2008) has a seminal paper on inefficient credit booms. Others propose regulation of international capital flows (Korinek 2010) and taxation (Jeanne and Korinek 2010).

Related are economies in which collateral is used to back promises. The issuer of a promise in the contract period is required to back the promise with collateral. In the spot market/trading period, the issuer can either honour the promise or default, handing over the collateral. But the value of collateral is endogenous in the spot market, determined by the forces of supply and demand at that time. Maximising agents take prices as given and do not take into account that their actions in the contract period, the promises they issue, and their savings and collateral determine ex post spot market prices. That is, there is a collateral constraint facing the issuers of promises that has in it those spot market prices. The problem of haircuts – in which the collateral backing the loans receives deep discounts when markets seem to suffer from illiquidity – has rightly received much attention (see, e.g., Begalle et al. 2013, Geanakoplos 2010, Gorton and Metrick 2012, and Krishnamurthy et al. 2012).

Likewise, the well-known Diamond and Dybvig bank-run environment can, in the no-run equilibrium at least, achieve an information-constrained efficient allocation. But this is undercut when retrading in a bond market is allowed, a point made forcefully in the seminal work of Jacklin (1987). Farhi et al. (2009) use this environment to argue for portfolio restrictions in the regulation of financial institutions.

On the flip side, so to speak, Hart and Zingales (2011) study an economy where markets for the forward sale of labour are precluded due to human capital considerations. Ironically, this leads to excess savings, not over-borrowing; savings back liquidity instruments used in trade when there are Wicksell absence-of-double-coincidence-of-wants in real goods.

A generalised framework

In our own research (Kilenthong and Townsend 2014 a, b), we can cast every one of these seemingly different environments as an example economy of a larger, generalised framework.

The key is that there are extra constraints typically binding on a subset of agent types which contain market clearing prices.

These can be ex ante security prices, ex post prices, or both.

The price-containing constraints – when binding – are indeed the definition of pecuniary externalities.

Examples are, again, collateral constraints, spot market budget constraints in incomplete markets, retrading entering into incentives to take ex ante action or announce ex post shocks truthfully, no default conditions, or the price of liquidity assets used in trades.

A market-based solution

We then go back to the first principles and show how to design financial contracts and markets in such a way that ex ante competition can achieve a constrained-efficient allocation, as Arrow (1969) made clear some time ago. For us, the markets for contracts over the ‘market fundamentals’ – those aspects of the environment which determine the market-clearing price, e.g., the valuation of collateral – are missing. Specifically, we show how bundling, exclusivity, and additional markets internalise these pecuniary externalities. The main point is that, unlike the literature, we do not need to identify and quantify some policy intervention. With the appropriate ex ante design we can let markets solve the problem.

There are several key ingredients in our approach to create these missing markets.

First, we define a new object called a type’s ‘discrepancy from the market fundamental’, and in equilibrium, by definition, the sum of individual discrepancies must be zero (but discrepancies are nontrivial, some types on one side of the market and some on the other).

Second, we give this discrepancy a common price per unit discrepancy, determined by a market (but the quantity discrepancy depends in part on observed heterogeneity).

Third, we allow agents to contract ex ante on the market fundamental determining the state-contingent spot-market clearing price.

For example, for the collateral environment, we create security exchanges in which the value of collateral used for clearing ex post is pre-determined for the entire range of values for collateral, including out of equilibrium values.

Implementation

Practically, the markets for the rights to trade can be implemented using markets for certificates, each of which specifies the security exchange a trader wants to be in, at a price paid (or is willing to be in), at a price received, and the amount of the discrepancy from the fundamental that the trader will be holding. These are like market participation rights with market access fees, but for us rather than a fixed fee independent of volume as in contemporary markets, that volume is implicit in the pre-trade position of the trader and the market fundamental.

These markets for rights to trade will be opened in the contracting period, and traders can buy any certificate they want and can afford, or be compensated if this puts them in a disadvantageous position. When there is more than one active exchange for a given state contingent contracted price, we allow for queuing with randomised execution of trade. That is, traders will buy an actually fair lottery over certificates at the beginning of the contracting period, and then a platform/utility exchange will draw the outcome of the lottery and assign the certificate accordingly, to get the fractions of traders right at the end of the contracting period.

In the execution period, markets are segregated or restricted in the sense that a trader with a certificate can trade in the specified security exchange only so long as its discrepancy from the fundamental on its certificate is the same as the true one, or at least the one agreed to in the contracting period. If a household or trader comes to a wrong security exchange or holds an inconsistent discrepancy from the fundamental, its right to trade will be forfeited. This mechanism requires a technology that can verify ex post, in the execution period, a household’s collateral/savings and its endowment profiles.

Registration and exclusivity might seem at first blush to be demanding requirements, but these have become standard in the operation of US financial markets, as we now argue. In contemporary financial markets, traders do not take physical possession of securities. The US has moved from a system in which securities and money (checks) were used to complete trades bilaterally, with one or the other in currier black bags being raced around downtown NYC via bicycle, subject to a deadline, to a new system in which securities are registered and fixed in place and do not change hands physically.

A primary institution is the Depository Trust and Clearing Corporation (DTCC). Essentially, all issuance and ownership is now electronic. Older securities are in a vault. Ownership changes by trading on financial markets. There is a Trade Reporting Facility (TRF). One of the most obvious exchanges is the New York Stock Exchange. An order to buy comes with the name of the trader, typically an identification number, and desired trades (limit order). Of course, much of this information is not revealed to the public, but the exchangers know, regulators can, in principle know, and records are kept.

That is, trades are reported in practice such that the trading venues are disclosed to the public, whereas the trader identities are only known to the venues and regulators. In contrast, over-the-counter trades might seem to be bilateral or among dealers and unobserved, but at least the trade in some derivatives (credit default insurance) is now regulated under the Dodd-Frank legislation, and, the point here, the collateral is recorded in a central clearing party (CCP). Further, the responsibility to finalise trade, to transfer securities and money now lies after Trade-plus-2 days with that clearing party. Evidently, many new registration and clearing platforms are being created. These private entities are a bit like our intermediaries, i.e., trades are netted and cleared though them. Exclusivity is also not uncommon. For example, some of the dark pools do not want to deal with hedge funds or high frequency (computer) traders, so they just prohibit them from entering the platform. Our more general point is that these kinds of reforms have been implemented and, in that sense, our proposal would not seem to require more technology.

References

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Begalle, B, A Martin, J McAndrews, and S McLaughlin (2013), “The risk of fire sales in the tri-party repo market”, Federal Reserve Bank of New York Staff Report # 616.

Bianchi, J and E Mendoza (2012), “Overborrowing, financial crises and macro-prudential policy”, Working Paper.

Caballero, R and A Krishnamurthy (2001), “International and Domestic Collateral Constraints in a Model of Emerging Market Crises”, Journal of Monetary Economics 48 (3), 513-548.

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Farhi, E, M Golosov, and A Tsyvinski (2009), “A Theory of Liquidity and Regulation of Financial Intermediation”, Review of Economic Studies 76 (3), 973-992.

Geanakoplos, J (2010), “The Leverage Cycle”, in D. Acemoglu, K. Rogoff, M. Woodford (Eds.), NBER Macroeconomics Annual 2009, Chicago and London: University of Chicago Press, 1-65.

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Jacklin, C (1987), “Demand Deposits, Trading Restrictions, and Risk Sharing”, in Contractual Arrangements for Intertemporal Trade, Minneapolis, MN: University of Minnesota Press, 26-47.

Jeanne, O and A Korinek (2010), “Managing credit booms and busts: A pigouvian taxation approach”, National Bureau of Economic Research Working Paper No. 16377.

Kilenthong, W T and R M Townsend (2014a), “Segregated Security Exchanges with Ex Ante Rights to Trade: A Market-Based Solution to Collateral-Constrained Externalities”, National Bureau of Economic Research Working Paper No. 20086.

Kilenthong, W T and R M Townsend (2014b), “A Market Based Solution to Price Externalities: A Generalized Framework”, National Bureau of Economic Research Working Paper No. 20275.

Korinek, A (2010), “Regulating capital flows to emerging markets: An externality view”, Working Paper.

Krishnamurthy, A, S Nagel, and D Orlov (2012), “Sizing up repo”, National Bureau of Economic Research Working Paper No. 17768.

Lorenzoni, G (2008), “Inefficient Credit Booms”, Review of Economic Studies 75 (3), 809-833.