Queue Priority and Adverse Selection in Liquid ETF Market Making

Summary

The document considers whether a new market maker can earn a spread in highly liquid ETFs when the best bid and ask are one tick apart and display substantial size. Its central lesson is that liquidity provision earns a premium only when counterparties need liquidity at prices that leave the provider a favorable spread. If the book is already well supplied, joining the queue may be the only practical option, and competing for execution priority can be difficult.

The answer identifies two possible advantages: obtaining order flow or accessing venues or flow where an order receives priority, such as internalized trades. It also describes the tradeoff between being filled as the queue turns over while the price remains stable and being filled just before the market moves through the quote. The discussion is conceptual; it gives no measured profitability, trading rules, or venue-specific analysis. It therefore offers a useful framing of queue competition and adverse selection, but does not establish whether any particular ETF or market-making approach is viable.

Key ideas

• Liquidity provision is profitable only when executions occur at a favorable bid-ask spread.
• A crowded, tight book can leave a new market maker waiting behind existing orders.
• Order-flow access or execution priority may help a market maker compete for fills.
• A fill can result from ordinary queue turnover or from the market moving through the quoted price.

Tags

# How to make markets for highly liquid assets?


# How to make markets for highly liquid assets?












I'm looking at the level-2 data of some ETFs and trying to figure out whether it's possbile to design a market making strategy. When looking at the data, I find these ETFs to be highly liquid: at the top of the book, all price levels are next to each other by just one price tick and with very large volume, leaving me no space to insert my orders and the only choice seems to be waiting in the queue.

I have no experience in market making and the situation seems to indicate that there's no liquidity premimum any more to capture in these assets. I'm guessing there are already many designated market makers working on these assets and competiting with each other, thus leaving no room for later players.

My question is, what should a market maker do if he/she tries to enter this market, or how do existing market makers gain advantage over competitors?

## Answer by krkeane (score 4, accepted)

https://quant.stackexchange.com/a/75375

Don't.

You get paid to provide liquidity. Sounds like none is required.

For you to make money, you need to transact with a bid-ask spread in your favor. To get to the head of the queue, you could purchase order flow or otherwise find a place where you have priority interacting with flow (perhaps "internalized" flow).

There is a balance between the book turning over (enter at the end of the queue, proceed to the front with volume, and have size remaining behind you when filled, aka price unchanged); and, the book being run over (you are filled, but the market traded through you).

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.