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I've been browsing market making codebases and I've noticed most of them tend to create multiple orders on each side.

Originally I thought having orders on each side is an advanced approach but here's a very simple market maker for Bitmex crypto exchange it uses multiple orders on each side: https://github.com/BitMEX/sample-market-maker/blob/master/market_maker/market_maker.py#L310

What are the benefits of this approach? Here's the best I can do:

  1. In case of market maker which goal is generating liquidity, we have to keep bid-ask spread within a specific range. So it might make sense to put, let's say, three orders: a small one at the top of the order book, a middle one in the middle of the maximum bid-ask spread we have to guarantee and the largest one as we have to keep the spread at this level. Supposedly it should help us loose less money in case of trade doesn't go our direction

  2. In case of market makers which goal is generating profit (like the codebase above), I don't really see much benefit from putting an order somewhere besides the top of the order book as otherwise our order will not be executed at least on one side and we'll end up with huge slippage. But I have a feeling I'm missing something

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I've read this question and the other question you asked and I hope I can help.

The important thing to realize that in any market multiple market makers operate and they are all trying to optimize their risk adjusted return. A market maker earns a return buying low and selling high. Suppose you are the only market maker and you quote this spread:

1 | Bid 100 @ $99 | Ask 100 @ $101

the best thing that can happen is that a liquidity seeker sells $100 @ 99 (remember that $99 is the price for which the market maker is buying) and immediately can sell $100 @ 101 to another liquidity seeker. After this, you have no position and therefore no risk but more importantly: you paid $9900 and received 10100 netting you $200!

In this situation you would be taking some risk as the market can move and you can easily get into the situation where you bought 1000 of shares which are now worth significantly less. But suppose you manage your risks well and you make a nice profit every day. Such a nice profit will surely attract competition and they can make sure to get more business than you by simply quoting a more narrow spread.

2 | Bid 100 @ $99.50 | Ask 100 @ $100.50

whenever you quote

3 | Bid 100 @ $99.00 | Ask 100 @ $101.00

You could react by in response quote an even narrower spread:

4 | Bid 100 @ $99.75 | Ask 100 @ $100.25.

Of course, this narrowing of the spread can't continue very long. However, I hope it is now clear that

It is not from the benevolence of BBB Market Makers that we expect our narrow spreads, but from their regard to their own interest. -- With apologies to Adam Smith

which leads to competitive pressuresin market making.


The above also gives a hint on why these market making algorithms quote prices at multiple levels:

You would like to quote only the first spread and do lots of trades on both sides. Thanks to competition this will not happen, other market makers will quote slightly narrower spreads and they will make a lot of trades (earning less per round trip but making up in volume). Therefore, you also decide to narrow your spread reducing your own margin but hopefully also making up in volume. Now what do you do with your original quote? You could stop quoting it by why would you? You might just get lucky and a deep-pocketed liquidity seeker might trade against all better prices and yours. If this happens you get a better price than the situation you would just quote a narrow spread (and hope that the market hasn't moved against you permanently).


Attack86 mentions a number of scenario's where the market makers are incentivized by the exchanges or have other reasons:

  • They get a profit share when they attain specific liquidity targets. In that case they might optimize for making the target instead of making a profit through trading (e.g. TP-ICAP's iSwap or Liffe's Ultra Long Gilt contract).
  • Others just aim to provide liquidity to their customers but don't necessarily want to trade all the time, this is common in investment bank fixed income trading.
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  • $\begingroup$ some MM's also get profit share from the exchange/operator if they attain specific liquidity targets, such as maintaining average spd for some duration (e.g. TP-ICAP's iSwap or Liffe's Ultra Long Gilt contract), in that scenario algos exist to attain these targets and minimise trading, i.e. always be second in queue. Otherwise some MMs brand themselves on liquidity provision but don't necessarily want to actively trade (since it is not necessarily profitable), examples again on iSwap and Bloomberg and Tradeweb. This is very common in investment bank fixed income trading. $\endgroup$ – Attack68 Jul 24 '18 at 16:07
  • $\begingroup$ @Attack68 incorporated your comment, what do you think? $\endgroup$ – Bob Jansen Jul 24 '18 at 16:21
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    $\begingroup$ Looks good to me. And I don't even mind you made me 18 years younger. $\endgroup$ – Attack68 Jul 24 '18 at 16:33

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