Arbitrage networks

This paper is studies the general equilibrium implications of arbitrage trades by strategic players in segmented financial markets. Arbitrageurs exploit client`ele effects and choose to specialize in one category of trades, taking into consideration all other arbitrage strategies. This results in an equilibrium network of arbitrageurs. The optimal network for arbitrageurs is of the hub-spoke kind. The equilibrium network, in contrast, is never optimal for arbitrageurs and is never hub-spoke. The reason is that equilibrium networks suffer from a Prisoner’s Dilemma problem that prevents network externalities from being internalized. We show that, as the number of intermediaries grows, equilibrium allocations converge to those of the frictionless complete-markets Arrow-Debreu economy.