Enigma of Fair Value in Order Book Market Making

The Enigma of Fair Value in Order Book Market Making

Market making, the practice of simultaneously quoting bid and ask prices for a financial instrument, is a complex endeavor. Industry insiders often mention using a "fair value" signal to inform their quoting strategy. While this concept is relatively straightforward in a Request-For-Quote (RFQ) environment, its application within a Central Limit Order Book (CLOB) system raises some intriguing questions. This article delves into the role of fair value in order book market making, exploring its potential uses and limitations.

In an RFQ system, where market participants directly solicit quotes from dealers, fair value plays a crucial role.1  Dealers, armed with their internal valuation models, determine a fair price for the instrument and quote bid and ask prices around this value, incorporating a spread to generate profit. Since there's no central order book, the dealer's quote stands as their offer to trade.

However, the dynamics shift dramatically in a CLOB environment. The CLOB provides a transparent, real-time display of all outstanding buy and sell orders, creating a continuous auction.2  Here, the best bid and ask prices are readily visible, and market makers interact with these existing orders. The question then arises: how does fair value fit into this picture?

Your observation highlights a critical point. If the fair value is above the best ask price in the CLOB, simply quoting around that value wouldn't make sense. Your bid would immediately cross the best ask, resulting in an immediate trade rather than establishing a market making presence. Similarly, if the fair value is below the best bid, your ask would cross the best bid. This clearly demonstrates that fair value cannot be directly translated into bid and ask quotes in a CLOB without considering the existing order book.

So, what purpose does fair value serve in order book market making? It's not about blindly quoting around a single point estimate. Instead, fair value acts as a crucial anchor, informing a more nuanced market making strategy. Here are some potential uses:

1. Informed Order Placement: Even if you don't directly quote around the fair value, it informs your decision on where to place your bids and asks. If your fair value is significantly above the current best ask, you might be more inclined to place bids closer to the best bid, anticipating upward price movement. Conversely, if your fair value is below the best bid, you might position your asks closer to the best ask. This allows you to capitalize on perceived mispricings relative to your internal model.

2. Inventory Management: Fair value plays a significant role in managing your inventory. If you're short an asset and your fair value is above the current market price, you might be hesitant to sell more. Conversely, if you're long and your fair value is below the market, you might be reluctant to buy more. Fair value helps you manage your risk exposure and avoid accumulating excessive inventory in unfavorable market conditions.

3. Mid-Price Referencing: While you can't always quote directly around the mid-price, fair value can inform your strategy for doing so. If your fair value is close to the current mid-price, you might choose to place both bid and ask orders around the mid, effectively providing liquidity on both sides of the market. This strategy is particularly useful in liquid markets where the risk of immediate execution is lower.

4. Dynamic Spread Adjustment: Fair value can inform how wide or narrow your spreads should be. In volatile markets where your fair value is rapidly changing, you might widen your spreads to compensate for the increased risk. Conversely, in stable markets where your fair value is relatively stable, you might narrow your spreads to attract more order flow.

5. Signal for Aggressive Trading:  A significant divergence between your fair value and the market mid-price can signal a potential trading opportunity. If your fair value is substantially higher than the market price, you might choose to become more aggressive on the bid side, potentially even crossing the spread to take advantage of the perceived mispricing.

It's important to note that market making is not a passive exercise. It requires constant monitoring of the order book, reacting to market movements, and dynamically adjusting your quoting strategy. Fair value is a critical input into this process, but it's not the sole determinant. Market makers also consider factors such as order book depth, volatility, news events, and their own risk appetite.

In conclusion, while fair value isn't directly translated into quotes in a CLOB, it serves as a cornerstone of informed market making. It provides a framework for order placement, inventory management, spread adjustment, and identifying potential trading opportunities. Successful market makers leverage fair value in conjunction with other market signals to navigate the complexities of the order book and contribute to market efficiency.