Augmenting Markets with Mechanisms

We compute optimal mechanism designs for each of a sequence of size-discovery sessions, at which traders submit reports of their excess inventories of an asset to a session operator, which allocates transfers of cash and the asset. The mechanism design induces truthful reports of desired trades and efficiently reallocates the asset across traders. Between sessions, in a dynamic exchange double-auction market, traders strategically lower their price impacts by shading their bids, causing socially costly delays in rebalancing the asset across traders. As the expected frequency of size-discovery sessions is increased, market depth is further lowered, offsetting the efficiency gains of the size-discovery sessions. Adding size-discovery sessions to the exchange market has no social value, beyond that of a potential initializing session. If, as in practice, size-discovery sessions rely on price information from the exchange to set the terms of trade, then bidding incentives are further weakened, strictly reducing overall market efficiency. Keywords: mechanism design, price impact, size discovery, allocative efficiency, workup, dark pool, market design.