Equilibria and incentives for illiquid auction markets

TL;DR

This paper models a two-player auction game to analyze how incentives influence liquidity and price formation, showing that quadratic fee incentives can promote trading and improve market efficiency.

Contribution

It introduces a simplified game-theoretic model linking market spreads with signal strength and derives optimal fee structures to incentivize liquidity.

Findings

Without incentives, markets are inefficient and non-trading.

Quadratic fees based on half spreads induce transactions.

Optimal fee levels can be quantitatively determined for liquidity provision.

Abstract

We study a toy two-player game for periodic double auction markets to generate liquidity. The game has imperfect information, which allows us to link market spreads with signal strength. We characterize Nash equilibria in cases with or without incentives from the exchange. This enables us to derive new insights about price formation and incentives design. We show in particular that without any incentives, the market is inefficient and does not lead to any trade between market participants. We however prove that quadratic fees indexed on each players half spread leads to a transaction and we propose a quantitative value for the optimal fees that the exchange has to propose in this model to generate liquidity.