Adverse Selection Risks
Adverse selection risks occur when a market maker trades against an informed participant who has better information about the asset's future price. The market maker is essentially selling an option to the informed trader, who will only trade when the price is about to move in their favor.
This leads to losses for the market maker, who then tries to mitigate this by widening their spreads or withdrawing from the market. In the context of crypto, this is a major concern due to the high number of informed traders and the speed of information flow.
Managing this risk is essential for any liquidity provider. It influences the design of trading algorithms and the structure of order books.
Glossary
Price Discovery
Price ⎊ The convergence of market forces, particularly supply and demand, establishes the equilibrium value of an asset, a process fundamentally reliant on the dissemination and interpretation of information.
Order Flow
Flow ⎊ Order flow represents the totality of buy and sell orders executing within a specific market, providing a granular view of aggregated participant intentions.