macrocephalopod

A “pure” market making operation is based on clipping spreads, ie buy low, sell high, keep inventory low, keep risks (eg greeks) tightly hedged. Skew your bid/offer based on your inventory to try and offload it as quickly as possible without impacting your profit too much.

This kind of trading has enormous risk-adjusted returns (Sharpe > 10, ~no down days) but it’s hard to scale it because your P&L is a function of two things — volume and volatility — that you don’t have any control over.

This is a problem because the costs of running a pure MM firm (mainly infrastructure and employee comp) are increasing and profit margins are decreasing. So many firms turn to prop trading as a way to increase P&L at the cost of some Sharpe.

One way to approach this is to make your price skew dependent on factors other than your inventory, eg if you think the market is going up you skew prices a little higher to encourage people to sell to you and discourage them from buying from you.

(To some extent even pure MM firms do this since they use very short term signals based on the order book in addition to their inventory to skew prices, but I’m talking about adding longer term signals using a wider variety of input data.)

This also becomes hard to scale after a while because it relies on having a centralised book which has a view on everything, this creates coordination problems and increases risk of IP leakage as many more people can see the whole system.

So the approach that many places gravitate towards is having a central market making book (just using inventory and simple signals to skew prices) and satellite prop books which exist purely to trade with the firm’s capital. These prop books can trade with the MM book

under some agreement, generally very favourable pricing if they are taking risk off the central book and less favourable if they are adding risk. These books can be run be completely independent teams which reduces coordination problems and IP leakage risk.