Trading complex assets - a good framework for thinking about market behavior

A new article in the Journal of Finance, "Trading Complex Assets" provides some very good analysis on potential market behavior. The three authors, Bruce Carlin, Shimon Kogan, and Rich Lowery, take an innovative experimental approach to test some of their hypotheses on trading. They are able to conclude from their laboratory experiments that higher complexity in assets leads to higher price volatility, lower liquidity, and decreased trade efficiency. This is not due to noise from estimation error but from changes in behavior of the traders who adjust their bidding strategies when faced with complexity. Simply put, traders are less willing to trade more complex assets because they are afraid that their trade counter party may know more or have an information advantage in any transaction.

Wait, I thought derivatives are supposed the help the market? I thought there was supposed to be demand for these complex financial products because specialized bets can be made in the market? It seems we have to go back to the old poker advice, "If you do not know who is the patsy, then you are  it". When the trading instrument gets too complex, you get concerned about who will trade with you.

Their conclusion is based on adverse selection in the trading of any complex asset. The more complex the instrument, the more likely you may be at a disadvantage relative to the person who will take the other side of the trade. Perhaps the other party knows more? Perhaps he is too eager to trade? Maybe he is only willing to do this because he has a better idea of true valuation. In a case like that, where you may be less sure of your own idea of value, it may be prudent to walk away. Add some more uncertainty or add more complexity and there should be less willingness to trade. 

Anything that is hard to value should be subject to this adverse selection. A corporation which is hard to understand should have adverse selection. A security that has little public information should be subject to the problem. Even a currency could be a complex asset if we cannot determine or estimate the drivers of valuation. Under times of stress and uncertainty, we should see more adverse selection, less trading and thus less liquidity. 

There are some powerful ideas in their work and even if you do not fully grasp the experimental tests, it is worth a read.