Adverse selection
Why it creates spreads#
If some takers know the outcome, a quote that is hit is more likely to have been wrong. A zero-profit market maker widens its spread until the gains from uninformed traders pay for the losses to informed ones. For an event contract with a share of informed takers, the Glosten–Milgrom spread is
which equals exactly at 50¢ (derivation and simulation).
How it is measured#
With mark-outs: the change in fair value at fixed horizons (1 second, 1 minute, 1 hour) after each fill, signed from the market maker's side. Consistently negative mark-outs mean the flow is informed. Averaging mark-outs by counterparty type, time of day and proximity to scheduled news shows where adverse selection is concentrated. In event markets it is mostly in the seconds after a release.
Defences#
- Widen or pause quotes around scheduled information events.
- Parse primary sources directly so quotes update before informed takers arrive.
- Skew quotes against inventory so repeated one-way flow gets progressively worse prices (simulation).
- Reduce displayed size where informed flow is likely.
Questions#
What is adverse selection in market making?
The risk that the traders who trade against a market maker's quotes know more than it does, so that its fills are systematically followed by adverse price moves.
How do market makers protect against adverse selection?
By widening spreads around information events, reacting faster to primary sources, skewing quotes against inventory and limiting displayed size.