Market Making in Spot Precious Metals

TL;DR

This paper develops a stochastic model for the EFP spread in precious metals, enabling near real-time optimization of market making strategies by capturing the spread's dynamics and co-integration with futures.

Contribution

It introduces a nested Ornstein-Uhlenbeck process model for the EFP spread and a computational method for real-time strategy optimization in precious metals market making.

Findings

Effective modeling of EFP spread dynamics.

Real-time strategy optimization demonstrated.

Enhanced market making performance potential.

Abstract

The primary challenge of market making in spot precious metals is navigating the liquidity that is mainly provided by futures contracts. The Exchange for Physical (EFP) spread, which is the price difference between futures and spot, plays a pivotal role and exhibits multiple modes of relaxation corresponding to the diverse trading horizons of market participants. In this paper, we model the EFP spread using a nested Ornstein-Uhlenbeck process, in the spirit of the two-factor Hull-White model for interest rates. We demonstrate the suitability of the framework for maximizing the expected P\&L of a market maker while minimizing inventory risk across both spot and futures. Using a computationally efficient technique to approximate the solution of the Hamilton-Jacobi-Bellman equation associated with the corresponding stochastic optimal control problem, our methodology facilitates strategy optimization on demand in near real-time, paving the way for advanced algorithmic market making that capitalizes on the co-integration properties intrinsic to the precious metals sector.