Market Making Strategies

Passive market making is the simplest and most fundamental approach: continuously quote bid and ask prices, capture the spread when filled.

PASSIVE MARKET MAKING BASICS

Revenue per round-trip: 10,000 × $0.004 = $40
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How wide should your spread be?

SPREAD COMPONENTS

SPREAD CALCULATION

Base spread = AS_cost + Inv_risk + Op_cost + Profit_margin

How much should you quote?

POSITION SIZING FACTORS

SIZING FORMULA

Max_size = MIN(
Capital / (2 × price), # Can fund both sides
Risk_budget / (price × vol), # Volatility-based risk limit
Market_depth × depth_factor, # Don't dominate the book
Typical_trade_size × 3 # Reasonable fill expectation
)

Practical size: ~15,000 XRP per side
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Market makers accumulate inventory as trades don't balance perfectly:

INVENTORY ACCUMULATION EXAMPLE

Hour 1: Sell 5,000 XRP (inventory: -5,000)
Hour 2: Buy 8,000 XRP (inventory: +3,000)
Hour 3: Buy 6,000 XRP (inventory: +9,000)
Hour 4: Sell 2,000 XRP (inventory: +7,000)

Now holding 7,000 XRP long position.
If price drops 2%, you lose $280 regardless of spread earned.

Adjust quotes to encourage offsetting trades:

SKEWING MECHANICS

- Bid: $1.998
- Ask: $2.002
- Mid: $2.000

- Shift quotes down to attract buyers
- Bid: $1.996 (less attractive to sellers)
- Ask: $2.000 (more attractive to buyers)
- Mid: $1.998 (shifted down)

- Shift quotes up to attract sellers
- Bid: $2.000 (more attractive to sellers)
- Ask: $2.004 (less attractive to buyers)
- Mid: $2.002 (shifted up)

SKEWING FORMULA

skew = inventory × skew_factor

- Conservative: 0.5-1.0 bps per 1% of max inventory
- Aggressive: 1.0-2.0 bps per 1% of max inventory

- Inventory: +10,000 XRP (20% of max 50,000)
- Skew factor: 1.0 bp per 1%
- Skew: 20 × 1.0 = 20 bps
- Shift mid down by 10 bps (half the skew)

Hard limits prevent catastrophic inventory buildup:

POSITION LIMIT FRAMEWORK

Tiered response to inventory:

Inventory Level Response
─────────────────────────────────────────────
0-25% of max Normal quotes, no adjustment
25-50% of max Begin skewing
50-75% of max Aggressive skewing
75-90% of max One-sided quotes only
90-100% of max Stop quoting, actively reduce

100% of max Emergency protocols

• Widen spreads dramatically
• Cross spread to reduce (accept loss)
• Hedge on CEX if available
• Alert for manual intervention

Offset inventory risk on other venues:

HEDGING APPROACHES

- Accumulate inventory on XRPL DEX
- Hedge with opposite position on Binance/Kraken
- Capture DEX spread while neutralizing direction
- Cost: CEX fees + execution slippage

- XRPL DEX: Buy 10,000 XRP at $1.998
- Binance: Short 10,000 XRP (via perpetual) at $2.001
- Net position: Flat
- Locked-in profit: $30 (minus fees)

- Hedge XRP with BTC position
- Imperfect but available when XRP hedging isn't
- Beta-adjust the hedge size
- Cost: Basis risk + fees

- Force inventory to zero at intervals
- Cross spread if necessary
- Accept occasional loss for position clarity
- Cost: Spread crossing when forced

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Spreads should respond to market conditions:

VOLATILITY-BASED SPREAD ADJUSTMENT

Formula:
spread = base_spread × (1 + vol_multiplier × (current_vol / normal_vol - 1))

- base_spread: Your normal spread (e.g., 20 bps)
- vol_multiplier: Sensitivity to volatility (e.g., 1.5)
- current_vol: Recent realized volatility
- normal_vol: Long-term average volatility

- Base spread: 20 bps
- Normal volatility: 3% daily
- Current volatility: 6% daily (2x normal)
- Vol multiplier: 1.5

Adjusted spread = 20 × (1 + 1.5 × (2 - 1))
                = 20 × (1 + 1.5)
                = 50 bps

When volatility doubles, spread increases 2.5x.

Beyond skewing, widen spreads as inventory grows:

INVENTORY-SPREAD RELATIONSHIP

Logic: Higher inventory = higher risk = need wider spread

Formula:
spread = base_spread × (1 + inv_factor × (|inventory| / max_inventory)²)

The squared term makes spread grow faster as limits approach.

- Base spread: 20 bps
- Inventory factor: 1.0
- Current inventory: 40% of max

Adjusted spread = 20 × (1 + 1.0 × 0.4²)
                = 20 × 1.16
                = 23.2 bps

At 80% inventory:
Adjusted spread = 20 × (1 + 1.0 × 0.8²)
                = 20 × 1.64
                = 32.8 bps

Adjust based on competitive conditions:

COMPETITIVE SPREAD LOGIC

If (your_spread > best_spread + threshold):
    # You won't get filled, tighten if profitable
    new_spread = best_spread + small_margin

If (your_spread < best_spread):
    # You're best, can widen slightly
    new_spread = min(your_spread × 1.05, best_spread)

If (best_spread < your_minimum):
    # Can't compete profitably
    reduce_size_or_pause()

ADAPTIVE ALGORITHM

every update_interval:
    best_spread = get_market_spread()
    min_viable = calculate_minimum_spread()

if best_spread < min_viable:
        reduce_exposure()
    elif best_spread > target_spread × 1.5:
        increase_exposure()  # Opportunity
    else:
        normal_operations()

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Exploit price differences between venues:

CROSS-EXCHANGE ARBITRAGE

- XRP on Exchange A: $1.99 bid
- XRP on Exchange B: $2.01 ask
- Buy on A, sell on B, profit $0.02 per XRP

- Capital on both exchanges
- Fast execution (prices change quickly)
- Account for fees on both sides

ARBITRAGE ECONOMICS

- Taker fee Exchange A: 0.10%
- Taker fee Exchange B: 0.10%
- Total fees: 0.20%

Minimum profitable spread: >0.20%

- 0.20%+ differences are rare and brief
- HFT firms capture most opportunities
- For slower participants: Not viable as primary strategy

XRP-SPECIFIC OPPORTUNITY

- Monitor CEX price
- When significant move, hit stale DEX quotes
- Profit from information advantage

- DEX liquidity is thin
- Others doing the same
- 3-5 second execution means limited window

Exploit statistical relationships:

STAT ARB CONCEPTS

- XRP price deviates from "fair value" (e.g., vs. BTC)
- Bet on reversion to mean
- Requires accurate fair value model

- Price moving in direction tends to continue short-term
- Skew quotes in direction of momentum
- Increases adverse selection from informed traders

- Large orders tend to come in clusters
- After big buy, more buying likely
- Adjust quotes to benefit from prediction

XRP STAT ARB EXAMPLE

XRP typically trades at 0.000035 BTC (hypothetical)
Current price: 0.000033 BTC (5.7% below)

- Long XRP, short BTC equivalent
- Wait for reversion to mean
- Close both positions when spread normalizes

- "Mean" is unstable
- Deviation might be new normal
- Carry costs while waiting
- Correlation breaks during stress

Position around predictable events:

EVENT-DRIVEN MARKET MAKING

1. Escrow releases (1st of month)
2. Ripple quarterly reports
3. Regulatory announcements (often telegraphed)
4. Major ODL corridor launches

- Widen spreads (uncertainty)
- Reduce size (risk management)
- Be ready to provide liquidity when others pull out

- If outcome clear, tighten spreads quickly
- Capture volume from position adjustments
- Be early to re-provide liquidity

ESCROW RELEASE EXAMPLE

Day -1: Reduce position limits 50%
Day 0: Widen spreads 30%, continue reduced limits
Day +1: If no news, begin normalizing
Day +3: Full normal operations

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STRATEGY SELECTION MATRIX

Your Resources Recommended Strategies
────────────────────────────────────────────────────────────
<$50K capital, Simple passive on XRPL DEX
basic technology Wide spreads, small size
Focus on exotic pairs

$50-200K capital, Passive with inventory skewing
moderate technology XRPL DEX primary
Consider single CEX secondary

$200K-1M capital, Dynamic spreads, active inventory management
good technology Multi-venue (DEX + 1-2 CEXs)
Cross-venue hedging

$1M capital, Full dynamic strategies
professional tech Multi-venue with arbitrage
Statistical approaches viable
```

PROGRESSION ROADMAP

DO NOT SKIP STAGES. Each must be profitable before advancing.
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WARNING SIGNS YOUR STRATEGY ISN'T WORKING

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XRP-SPECIFIC OPPORTUNITIES

XRP CHALLENGES TO STRATEGY

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Assignment: Design a complete market making strategy for your specific situation.

Requirements:

1. Strategy Selection: Choose and justify primary strategy based on your resources
2. Parameter Specification: Define spreads, sizes, skewing factors, position limits
3. Risk Controls: Document inventory management, stop conditions, hedging approach
4. Expected Economics: Project P&L under base, stress, and optimistic scenarios
5. Implementation Plan: Steps to launch and timeline for optimization

Format: 2,500-3,500 words with quantitative specifications
Time Investment: 4-5 hours

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Q1: What should happen to spreads when inventory reaches 70% of maximum?
A: Spreads should widen (higher risk requires higher compensation)

Q2: If normal volatility is 3% and current volatility is 6%, how should a 20 bps base spread adjust with 1.5x vol multiplier?
A: Spread = 20 × (1 + 1.5 × (2-1)) = 50 bps

Q3: What's the primary purpose of inventory skewing?
A: To encourage trades that reduce inventory by making offsetting side more attractive

Q4: Why is cross-exchange arbitrage difficult for non-HFT participants?
A: Price differences close within milliseconds-seconds; slower participants can't capture them

Q5: What's the recommended progression for strategy development?
A: Prove profitability with simple strategy before adding complexity

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End of Lesson 5
Total Words: ~6,500