Adverse Selection & Markouts

All the views expressed below are the personal views of the author, and are not financial or investment advice.Every exchange needs its market makers. Liquidity (which is the availability of quotes in order books) is the lifeblood of any sensible exchange, and thus the presence of these entities is both necessary and desirable. Market making, however, is not an easy game to play!Every quote that is placed runs the risk of getting picked off by someone both sharper and faster, and if you aren’t careful, this can siphon off any potential profits. In this article, we will be covering the concept of adverse selection, which is where one market participant has more information than another, and uses it to their advantage. As part of this, we will also cover the concept of markouts, which can be used to measure it.It’s been quite a while since I’ve written! Since that time, AI has become highly prevalent in online writing. While I may use AI to research or code, I want to assure you that my writing (for better or for worse) is my own!How Does Market Making Work?As always, it’s worth actually describing what a market maker does first before looking at the behaviour in question. Naturally, if you are already well-versed, feel free to skip forward to the next section.A Basic CaseA market maker is like any other market participant, in that they can place and cancel orders, and carry out trades. The detail, however, is in how they behave. While many participants are trying to trade in some particular direction (e.g. long, because they think the price will go up), a market maker has an altogether different objective. For every one of the aforementioned takers, there must be a someone who provides the liquidity and takes the other side of the trade. That entity is typically the market maker, whose sole purpose is to provide quotes so that others may transact.To be upfront, I am not an expert on market making; however, the basics are relatively simple to understand. In the classic case, a market maker provides quotes to both buy (bids) and sell (asks/offers). The gap between these is known as the spread, and it is also in effect one of the market maker’s primary sources of profit. Traders will hit the quotes provided by the maker, and assuming the maker’s quotes don’t change, the maker will be buying at their bid, and selling higher at their ask (by the spread).While the specific quoting method varies, generally the market maker will have some view on what the fair price of the asset is, and will try and quote around this price. As the fair price of the asset changes, so will the market maker’s quotes.The bid/ask spreadIn general, a market maker is not trying to profit by holding on to a position while the price moves. In fact, it is often the opposite. Ideally, the market maker would prefer it if the price didn’t move much at all as long as trades are filling quotes on both sides at a reasonable rate. They can happily sit there all day and collect the spread as users buy / sell.Inventory RiskIn reality, prices move all the time. In fact, outside of a few “structurally stable” markets (such as stablecoin pairs, e.g. USDT/USDC), they can often move quite drastically! One of the biggest risks a market maker faces is that of inventory risk, which is the risk of holding an unhedged position (inventory), and being exposed to the price action of that symbol.Consider for instance, that you are a market maker on a BTCUSD perpetual future. This perp tracks the underlying price of Bitcoin, and is thus exposed to it. You have placed both bid and ask quotes on the book, and do not have any starting position. Say that these quotes are at \$69,000 and \$71,000 respectively, and the current fair price of the contract is right in the middle at \$70,000.An example of how quotes change around a new fair price.Because a maker is passive, you must wait for someone to hit your liquidity. Say that a trader comes along and hits the bid, causing you to buy 1 BTC at \$69,000. You are now long 1 BTC. Say that the price now dumps suddenly to \$65,000. Through no action of your own, you are now at an unrealised loss of \$4,000. The problem now is that you still need to quote. You start quoting around the fair price again, with a bid at \$64,000 and an ask at \$66,000 (the same spread). Another taker comes along and buys from you at \$66,000. You realise a loss of:$66,000 - $69,000 = -$3,000