Optimal Market Making in the Presence of Latency

TL;DR

This paper analyzes how latency affects optimal market making strategies for large-tick assets, using a Markov Decision Process model to evaluate profitability and risk in the presence of latency.

Contribution

It introduces a novel MDP-based framework to assess the impact of latency on market making profitability and risk, providing explicit criteria for profitability under latency conditions.

Findings

Market makers can earn positive profit with sufficient uninformed order flow.

Latency increases risk and negatively impacts market making performance.

Profitability depends on the balance between order flow and price jump rates.

Abstract

This paper studies optimal market making for large-tick assets in the presence of latency. We consider a random walk model for the asset price, and formulate the market maker's optimization problem using Markov Decision Processes (MDP). We characterize the value of an order and show that it plays the role of one-period reward in the MDP model. Based on this characterization, we provide explicit criteria for assessing the profitability of market making when there is latency. Under our model, we show that a market maker can earn a positive expected profit if there are sufficient uninformed market orders hitting the market maker's limit orders compared with the rate of price jumps, and the trading horizon is sufficiently long. In addition, our theoretical and numerical results suggest that latency can be an additional source of risk and latency impacts negatively the performance of market makers.