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Is it uncommon to provide liquidity in an asset without consideration of an outside market price? In other words, a market maker would set their bid ask quotes as a function of only their own inventory, asset volatility, risk tolerance, etc. and not what the broader market is quoting.

If I'm reading the below papers correctly, it appears they both quote bid asks with respect to an outside market price.

Dealing with the Inventory Risk https://www.math.nyu.edu/faculty/avellane/HighFrequencyTrading.pdf

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    $\begingroup$ In what respect is the market on the outside? Isn't it a direct connection between the market maker and the market in which the price will be the same for the market maker and the client. How can there exist an outside price different from the market maker's? $\endgroup$ – Mats Lind Sep 25 at 13:27
  • $\begingroup$ My interpretation is that more recent academic papers simulate a broader market price then use that price to determine optimal order placement in that broader market. But my thoughts were to establish a market maker on a separate order book. The order book would be in line with broader market via arbitrageurs but the bid asks and liquidity provided on that order book would only be a function of the market maker's inventory, etc. The market maker doesnt care what the broader market is quoting. Again, I might be missing something here. $\endgroup$ – vanhick Sep 25 at 14:10
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The existing (outside) market price must be a consideration to strategic market-maker.

The reason being is due to competitive market influences. If you imagine a price-taker acting on the best competitive quote he may be able to secure an arbitrage if acting on an outlier price or the market-maker may simply execute trades in only a single direction thereby building up a particularly one-sided inventory.

As an example, suppose that a market-maker believes the consensus price of 90 is wrong and in fact estimates the fair value at 100, then it would be foolish to quote prices of 98-102, whilst all others quote in the region of 88-92. Instead a better strategy would be to quote 90-94. That way the market-maker is still likely to build up a one-sided inventory but at a much more equitable market price.

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  • $\begingroup$ Understandable, however I suppose I was picturing the market maker to set their mid price equal to the market at t0, the first day of business. From that point on, the market-maker's bid asks would be a function of inventory, wealth, and risk aversion. Arbitrageurs would keep the market maker in line with the broader market. Maybe I'm trying to apply a monopolistic market maker to a multi-dealer market which may not be feasible. $\endgroup$ – vanhick Sep 25 at 13:34
  • $\begingroup$ you are not really in the position to be assessing the direction of the market and making bets on it as a market maker. you are a slave to the short term price fluctuations. even if you think you are right, are you really going to take on the massive inventory? what if you're wrong? you should be profiting off the spread mostly, not your prop bets on direction. $\endgroup$ – roz Sep 25 at 14:53
  • $\begingroup$ @roz I'm not quite following. In what sense am I taking a view? On the inventory? Isn't the inventory problem an inherent risk to any market maker? Presumably as inventory increases, your bid asks decrease which in turn would increase probability of ask side flow, lowering your inventory. The profit is in the spread as you note. $\endgroup$ – vanhick Sep 25 at 15:24

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