Econometrica: Jan, 2013, Volume 81, Issue 1
Strategic Liquidity Provision in Limit Order Markets
Kerry Back, Shmuel Baruch
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 for each ) 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.