The Formation of Exchanges: Risk Sharing and Information Aggregation

Abstract

This paper analyzes the welfare implications of information aggregation in a security-trading model where traders have both idiosyncratic endowment risk and asymmetric information about security payoffs. In the model a large market can be welfare-reducing --- i.e., the optimal market size is finite, even though a larger market makes security trading more liquid. The optimal market size balances two key forces in the model: (i) the risk-sharing (hedging) role of markets, which creates a positive externality amongst traders (for given beliefs about security payoffs), against (ii) the information-aggregation role of market prices, which leads to prices that are more correlated with security payoffs, thereby undermining the hedging function of markets and creating a negative externality amongst traders. In other words, the model offers a rational for a certain amount of market fragmentation: it protects the hedging function of markets against the adverse consequences of excessive information aggregation. Our analysis indicates that, in the presence of risk aversion and information aggregation, a market with infinitely many traders cannot be casually taken to be a welfare benchmark. We also show that information aggregation makes trade volume and price impact misleading as a guide to traders' welfare in large markets, and propose a simple observable measure called hedging effectiveness.