The Stoll Inventory Model, within the framework of crypto market microstructure and institutional options trading, describes how market makers adjust their bid-ask spreads based on their current inventory of an asset and the perceived risk of holding it. Its purpose is to explain the dynamic behavior of liquidity provision, demonstrating how market makers balance the profitability of their spread against the exposure of their positions in volatile digital asset markets. This model provides insights into optimal RFQ crypto quoting strategies.
Mechanism
The mechanism posits that a market maker with an excess long position in a crypto asset will widen their bid-ask spread to disincentivize further buying and encourage selling, thereby reducing their inventory risk. Conversely, an excess short position leads to a tighter spread to attract buying and reduce their short exposure. This adjustment is a continuous, automated process, responding to order flow imbalances and real-time market data, influencing the liquidity offered for institutional options.
Methodology
The methodology is rooted in optimal control theory and inventory management, aiming to minimize the market maker’s holding costs and price risk while maximizing trading profits. It incorporates factors like asset volatility, holding period, and the cost of capital for various crypto assets. The governing principle is to maintain a balanced book by actively managing inventory risk through dynamic spread adjustments, which directly impacts the pricing and depth of liquidity available for institutional crypto trading and options contracts.
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