Efficiencies and Inefficiencies in Spot Trade Markets
Publication Type:CFSP Research Briefs
This research brief, based on a paper by Weerachart Kilenthong and Robert M. Townsend, explores an externality and its market based solution in an economy with default and collateral requirement. Using a competitive general equilibrium with directly-collateralized and asset-backed securities, Kilenthong and Townsend analyze the interaction between the endogenous valuation of collateral and corresponding default decisions. This interaction generates a price externality which is evident in the literature.
The key point of this work is to propose a market based solution by creating markets that allow agents to contract on the state contingent price under which they will unwind their contract commitments. These appropriately designed markets in rights to trade deliver the correct prices and an efficient outcome. This work provides an alternative solution to an inefficiency problem in the financial markets, an alternative to a literature which largely focuses on some form of government intervention, e.g., portfolio restrictions, restrictions on savings, interest rate manipulation, fiscal policy, or taxes and subsidies.