We thank various anonymous referees for very helpful comments.
Strategic Liquidity Provision in Limit Order Markets
Article first published online: 24 JAN 2013
© 2013 The Econometric Society
Volume 81, Issue 1, pages 363–392, January 2013
How to Cite
Back, K. and Baruch, S. (2013), Strategic Liquidity Provision in Limit Order Markets. Econometrica, 81: 363–392. doi: 10.3982/ECTA10018
- Issue published online: 21 JAN 2013
- Article first published online: 24 JAN 2013
- Manuscript received May, 2011; final revision received June, 2012.
- Market microstructure;
- limit orders;
- market makers;
- trading game;
- nonlinear pricing
We characterize and prove the existence of Nash equilibrium in a limit order market with a finite number of risk-neutral liquidity providers. We show that if there is sufficient adverse selection, then pointwise optimization (maximizing in p for each q) in a certain nonlinear pricing game produces a Nash equilibrium in the limit order market. The need for a sufficient degree of adverse selection does not vanish as the number of liquidity providers increases. Our formulation of the nonlinear pricing game encompasses various specifications of informed and liquidity trading, including the case in which nature chooses whether the market-order trader is informed or a liquidity trader. We solve for an equilibrium analytically in various examples and also present examples in which the first-order condition for pointwise optimization does not define an equilibrium, because the amount of adverse selection is insufficient.