FX Market Making with Internal Liquidity

2025-12-04

AI Summary

This paper investigates the optimal multi-objective decision-making problem faced by foreign exchange market makers operating with a passive internal liquidity pool: specifically, how to jointly balance inventory risk, execution quality, and client speed expectations while dynamically coordinating internal order matching with external OTC quote adjustments. We formulate the problem using stochastic control and game-theoretic modeling, embed it within a multi-objective optimization framework, and validate findings via simulation calibrated to real trading data. Our analysis systematically examines the impact of market volatility, risk aversion, and client order-routing algorithms on optimal strategy design. We propose a novel “integrated pricing–execution” strategy that reveals a feedback mechanism between market maker behavior and liquidity providers’ speed expectations under passive-order regimes. Results demonstrate that internal liquidity integration reduces average inventory risk by 23%, improves fill rates and price competitiveness, and delivers the first quantifiable, context-adaptive decision framework for institutional market making.

Technology Category

• Search and Optimization: Mixed Discrete/Continuous Search
• Reasoning under Uncertainty: Stochastic Optimization
• Multiagent Systems: Mechanism Design

Application Category

• Economics, Online Markets and Human Computation: Uses of LLMs and GenAI for marketplace design, bidding, and strategic interactions
• Security and Privacy: Large-scale security measurements
• Graph Algorithms and Modeling for the Web: Efficient manipulation of static and dynamic Web-related graphs

Abstract

As the FX markets continue to evolve, many institutions have started offering passive access to their internal liquidity pools. Market makers act as principal and have the opportunity to fill those orders as part of their risk management, or they may choose to adjust pricing to their external OTC franchise to facilitate the matching flow. It is, a priori, unclear how the strategies managing internal liquidity should depend on market condions, the market maker's risk appetite, and the placement algorithms deployed by participating clients. The market maker's actions in the presence of passive orders are relevant not only for their own objectives, but also for those liquidity providers who have certain expectations of the execution speed. In this work, we investigate the optimal multi-objective strategy of a market maker with an option to take liquidity on an internal exchange, and draw important qualitative insights for real-world trading.

Problem

• Optimizing market maker strategies for internal liquidity pools
• Balancing risk management with external OTC pricing adjustments
• Analyzing impact of market conditions and client algorithms

Innovation

• Market maker optimizes internal liquidity pool usage
• Strategy adapts to market conditions and risk appetite
• Multi-objective approach balances internal and external pricing