A Utility Framework for Bounded-Loss Market Makers

TL;DR

This paper introduces a utility-based framework for market makers that ensures bounded loss, explores their properties, and analyzes the tradeoff between liquidity and worst-case loss, providing practical formulations and bounds.

Contribution

It establishes a unified framework connecting utility functions, scoring rules, and cost functions for market makers with bounded loss, including new insights on liquidity-loss tradeoffs.

Findings

Hyperbolic absolute risk aversion utility market makers are equivalent to weighted pseudospherical scoring rules.

Hanson's logarithmic market maker corresponds to a negative exponential utility market maker.

Tradeoff analysis shows no market maker can be optimal in all regimes for liquidity and loss.

Abstract

We introduce a class of utility-based market makers that always accept orders at their risk-neutral prices. We derive necessary and sufficient conditions for such market makers to have bounded loss. We prove that hyperbolic absolute risk aversion utility market makers are equivalent to weighted pseudospherical scoring rule market makers. In particular, Hanson's logarithmic scoring rule market maker corresponds to a negative exponential utility market maker in our framework. We describe a third equivalent formulation based on maintaining a cost function that seems most natural for implementation purposes, and we illustrate how to translate among the three equivalent formulations. We examine the tradeoff between the market's liquidity and the market maker's worst-case loss. For a fixed bound on worst-case loss, some market makers exhibit greater liquidity near uniform prices and some exhibit greater liquidity near extreme prices, but no market maker can exhibit uniformly greater liquidity in all regimes. For a fixed minimum liquidity level, we give the lower bound of market maker's worst-case loss under some regularity conditions.