Adverse Selection
Adverse selection is the risk that a Market Making agent — a liquidity provider — is systematically filled by counterparties who know more than it does. Informed traders are selective: they lift the market maker’s ask only when the true value exceeds it and hit the bid only when the true value is below it, so the market maker’s fills are biased toward losing trades — it buys just before prices fall and sells just before they rise. Glosten & Milgrom (1985) showed formally that informed trading alone generates a positive bid-ask spread even for a risk-neutral, zero-profit market maker with no inventory or processing cost: the spread is the adverse-selection premium.
In MDP/RL market-making research adverse selection is the failure mode most often omitted and most expensive to omit honestly. If a simulator assumes the mid-price and the order-arrival process are independent, the agent is filled at random with respect to future price moves and never pays the informed-flow penalty — producing the “large phantom gains” Lalor Swishchuk 2025 warn about. They mitigate it with an explicit adverse-fill mechanism. Any backtested market-making edge that ignores adverse selection, queue position and bid/ask (not mid-price) execution should be treated as an artefact, not alpha.
Connections
- Market Making — opposes (the core cost market makers manage), source: https://www.sciencedirect.com/science/article/pii/0304405X85900443
- Lalor Swishchuk 2025 — includes_costs (explicit adverse-fill mechanism), source: https://arxiv.org/html/2410.14504v2
- Phantom Gains in Backtests — causes (omitting adverse fills inflates P&L), source: https://arxiv.org/html/2410.14504v2
- Limit Order Book — part-of (informed flow inside the book), source: https://www.sciencedirect.com/science/article/pii/0304405X85900443
- Transaction Costs and Slippage — relates, source: https://arxiv.org/html/2410.14504v2