Risk Management for Market Makers

MARKET RISK CATEGORIES

OPERATIONAL RISK CATEGORIES

COUNTERPARTY RISK CATEGORIES

REGULATORY RISK CATEGORIES

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VAR CALCULATION FOR MARKET MAKERS

VaR answers: "What's the maximum I expect to lose over period X with Y% confidence?"

PARAMETRIC VAR

VaR = Position × Price × Volatility × Z-score × √Time

Interpretation: 95% of days, won't lose more than $6,600 from position movement.
5% of days (roughly monthly), could lose more.

LIMITATIONS OF VAR

EXPECTED SHORTFALL (CVaR)

Expected shortfall asks: "If we exceed VaR, how bad is it on average?"

Calculation:
ES = Average loss in worst (1-confidence)% of scenarios

This means: When we exceed VaR (5% of days), average loss is $10,000.

SCENARIO ANALYSIS FOR XRP MARKET MAKING

Define specific scenarios and estimate impact:

• XRP drops 20% in 1 hour

• Order books thin dramatically

• Can't exit at normal prices

• Primary exchange goes offline for 4 hours

• Can't adjust quotes or hedge

• Price moves against inventory

• SEC announces new XRP restrictions

• Price drops 30%, volatility spikes

• All correlations go to 1

• Exchange where capital held fails

• All funds on exchange lost

STRESS TEST FRAMEWORK

EXAMPLE STRESS TEST

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POSITION LIMIT FRAMEWORK

Maximum position = f(Capital, Volatility, Risk tolerance)

CALCULATION APPROACH

Method 1: Volatility-based
Max position = Capital × Risk% / (Price × Daily_Vol × Z-score)

Max position = $4,000 / ($2.00 × 4% × 1.65)
= $4,000 / $0.132
= 30,303 XRP

Method 2: Capital percentage
Max position = Capital × Position% / Price

Method 3: Stress-based
Max position = Survivable_loss / Stress_scenario_move

USE THE SMALLEST of all three methods.
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LOSS LIMIT HIERARCHY

BREACH RESPONSE

Breach Level 1-2: Pause trading, review, can resume after analysis
Breach Level 3: Stop for day, mandatory review
Breach Level 4: Stop for week, strategy review required
Breach Level 5: Stop indefinitely, complete reassessment
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EXPOSURE LIMIT TYPES

ADJUSTING LIMITS TO CONDITIONS

IMPLEMENTATION

def calculate_current_limits(base_limits, conditions):
vol_multiplier = get_volatility_multiplier(conditions.volatility)
drawdown_multiplier = get_drawdown_multiplier(conditions.current_drawdown)
event_multiplier = get_event_multiplier(conditions.pending_events)

current_limits = {}
for limit_name, base_value in base_limits.items():
current_limits[limit_name] = base_value * vol_multiplier *
drawdown_multiplier * event_multiplier
return current_limits
```

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EXCHANGE RISK SCENARIOS AND RESPONSES

CAPITAL ALLOCATION RULE

Never have more than 30-40% of total capital on any single exchange.
Keep 20-30% in self-custody as reserve.
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VOLATILITY EVENT RESPONSE PROTOCOL

BLACK SWAN PROTOCOL

TECHNOLOGY FAILURE SCENARIOS

RECOVERY PROCEDURES

XRP-SPECIFIC RISK SCENARIOS

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MARKET MAKER RISK FRAMEWORK

┌─────────────────────────────────────────────────────────┐
│ RISK GOVERNANCE │
│ • Risk appetite statement │
│ • Limit approval process │
│ • Exception handling │
│ • Regular review schedule │
└────────────────────────┬────────────────────────────────┘
│
┌────────────────────────┴────────────────────────────────┐
│ RISK IDENTIFICATION │
│ • Market risks │
│ • Operational risks │
│ • Counterparty risks │
│ • Regulatory risks │
└────────────────────────┬────────────────────────────────┘
│
┌────────────────────────┴────────────────────────────────┐
│ RISK MEASUREMENT │
│ • VaR / Expected Shortfall │
│ • Scenario analysis │
│ • Stress testing │
│ • Position/P&L monitoring │
└────────────────────────┬────────────────────────────────┘
│
┌────────────────────────┴────────────────────────────────┐
│ RISK MITIGATION │
│ • Position limits │
│ • Loss limits │
│ • Diversification rules │
│ • Hedging strategies │
└────────────────────────┬────────────────────────────────┘
│
┌────────────────────────┴────────────────────────────────┐
│ RISK MONITORING │
│ • Real-time dashboards │
│ • Automated alerts │
│ • Daily reports │
│ • Periodic reviews │
└─────────────────────────────────────────────────────────┘
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RISK BUDGET ALLOCATION

Total risk budget: Define max acceptable loss (e.g., 20% of capital)

USING RISK BUDGETS

Size positions so that worst-case market loss stays within market risk budget.
Design operations so that worst-case operational failure stays within operational budget.
Diversify across counterparties so single failure stays within counterparty budget.
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RISK DOCUMENTATION REQUIREMENTS

POST-INCIDENT REQUIREMENTS

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Assignment: Create a comprehensive risk management framework for your market making operation.

Requirements:

1. Risk Identification: Catalog all relevant risks for your specific operation
2. Quantification: Calculate VaR, define stress scenarios, estimate exposures
3. Limits: Specify position limits, loss limits, exposure limits with rationale
4. Monitoring: Define metrics, thresholds, and alert conditions
5. Procedures: Document response protocols for key scenarios
6. Review: Establish documentation and review schedule

Format: Policy document, 3,000-4,000 words
Time Investment: 4-5 hours

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Q1: What's the primary limitation of VaR as a risk measure?
A: Doesn't capture tail risk well; assumes normal distribution; backward-looking

Q2: If you're willing to risk 2% of $200K capital daily and volatility is 4%, what's max position at $2/XRP?
A: $4,000 / ($2 × 4% × 1.65) ≈ 30,000 XRP

Q3: What should happen when daily loss limit is breached?
A: Stop trading for the day; mandatory review before resuming

Q4: What's the recommended maximum capital concentration on a single exchange?
A: 30-40% of total capital

Q5: What triggers a black swan protocol response?
A: Extreme moves (>3 sigma); immediate kill switch and wait for stabilization

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End of Lesson 7
Total Words: ~6,900