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A Simple Strategy to Deal with Toxic Flow
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We model the trading activity between a broker and her clients (informed and uninformed traders) as an infinite-horizon stochastic control problem. We derive the broker's optimal dealing strategy in closed form and use this to introduce an algorithm that bypasses the need to calibrate individual parameters, so the dealing strategy can be executed in real-world trading environments. Finally, we characterise the discount in the price of liquidity a broker offers clients. The discount strikes the optimal balance between maximising the order flow from the broker's clients and minimising adverse selection losses to the informed traders.
Forward citations
Cited by 2 Pith papers
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Strategic OTC market making with reputation feedback
Performance-based flow gates make a single dealer's optimal quoting policy alternate between reputation-building and monetization, and can produce two stable reputation regimes.
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Optimal Quoting under Adverse Selection and Price Reading
An optimal market-making model with informed order flow and skew-sniffing that yields first-order quote corrections per client tier.
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