Liquidity Provision with Adverse Selection and Inventory Costs

Abstract

We study one-shot Nash competition between an arbitrary number of identical dealers that compete for the order flow of a client. The client trades either because of proprietary information, exposure to idiosyncratic risk, or a mix of both trading motives. When quoting their price schedules, the dealers do not know the client's type but only its distribution, and in turn choose their price quotes to mitigate between adverse selection and inventory costs. Under essentially minimal conditions, we show that a unique symmetric Nash equilibrium exists and can be characterized by the solution of a nonlinear ODE.

Keywords: liquidity provision, Nash competition, adverse selection, inventory costs

JEL Classification: C61, C72, C78, G14