On-Chain Auctions with Deposits

Second-price auctions with deposits are frequently used in blockchain environments. An auction takes place on-chain: bidders deposit an amount that fully covers their bid in a smart contract. The deposit is used as insurance against bidders not honoring their bid if they win. The deposit, but not the bid, is publicly observed during the bidding phase of the auction. The visibility of deposits can fundamentally change the strategic structure of the auction if bidding happens sequentially: Bidding is costly since the deposit has to be staked for a substantial amount of time. Thus, deposits can be used as a costly signal for a high valuation. This is the source of multiple inefficiencies: To engage in costly signaling, a bidder who bids first and has a high valuation will generally over-deposit in equilibrium, i.e. deposit more than he will bid. If high valuations are likely there can, moreover, be entry deterrence through high deposits: a bidder who bids first can deter subsequent bidders from entering the auction. Pooling can happen in equilibrium, where bidders of different valuations deposit the same amount. The auction fails to allocate the item to the bidder with the highest valuation.