How Market Design and Incentives Can Increase Order Book Depth

Summary

The document outlines two broad ways to increase displayed market depth: encourage more trading interest in an asset, or change market rules and incentives so participants are more willing to post liquidity. Examples of rule changes include increasing the minimum tick, paying liquidity providers through maker-taker fees, and adopting a pro-rata matching system, as used in some short-term interest rate futures markets.

These are proposed mechanisms rather than a comparative study: the document provides no data on how much depth each change creates or under what conditions it works best. It also highlights a trade-off. Measures that reward liquidity provision can benefit intermediaries such as dealers and high-frequency traders, while raising transaction costs for traders who take liquidity. The answer therefore suggests that increasing depth is possible through market design, but the effect on overall trading costs and who benefits should be considered.

Key ideas

• Market depth may grow when an asset attracts more trading interest and volume.
• Market rules can be changed to encourage participants to post liquidity.
• A larger minimum tick can increase depth at the best bid and offer.
• Maker-taker incentives and pro-rata matching are examples of liquidity-focused market design.
• Measures that reward liquidity provision may raise costs for liquidity takers.

Tags

# Increasing Market Depth


# Increasing Market Depth












Are there any sure-fire ways to increase market-depth that people have experience with?

Has much research been done/published on this subject?

## Answer by Shane (score 3)

https://quant.stackexchange.com/a/8835

Two general methods: you either need to increase general interest in the asset (i.e. increase volume) or make a mechanical change that will induce depth. Some obvious ways:

- Increase the minimum spread so that depth increases at the inside (you see this effect in low price stocks, where the minimum tick size is a constraint).

- Incentivize liquidity provision (e.g. maker taker model).

- Change the matching algorithm, for instance, to pro-rata as it is in short-term interest rate futures.

Some of these changes may result in higher t-costs for liquidity takers, as they primarily provide incentives to middle-men (dealers, high-frequency traders).

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.