Shading and Efficiency in Limit-Order Markets

Strategic shading of bids is typically viewed as a factor degrading the efficiency of auction outcomes. In continuous double auctions (CDAs), however, strategic bid-shading can actually improve allocative efficiency, as it counteracts the inherent inefficiency of CDAs induced by vagaries in order arrival sequence. This has been demonstrated most clearly in a standard CDA model by Zhan and Friedman (2007). Through a systematic simulation-based game-theoretic study, we show that the phenomenon also exhibits in symmetric mixed-strategy equilibria of Zhan and Friedman’s original game, and in equilibria of a richer dynamic model, more representative of financial markets. We find that the presence and degree of the effect can vary significantly, with the greatest benefit of strategic shading in markets with many traders or in the presence of factors such as adverse selection and limited trading opportunity.