Adverse Selection

Adverse selection is the oldest tax in market microstructure. A resting quote is a free option granted to everyone who can see it: the better-informed and the merely faster will exercise it exactly when it is mispriced, and leave it alone when it is not. Classical market-making theory — Glosten and Milgrom’s sequential trade model is the canonical treatment — shows that part of the bid-ask spread exists precisely as compensation for this: the market maker loses to informed flow and recoups it from uninformed flow, and the spread is where the arithmetic balances.

The concept cuts in both directions. From the maker’s side, adverse selection is being picked off on stale quotes by counterparties with a faster view of the same market — the risk that motivates defensive machinery such as quote staleness tolerance, spread widening into events, and hold windows like last look. From the taker’s side, the same logic inverts: when a counterparty holds discretion over whether a trade completes — a hold window, a requote, an internalised book — the trader’s fills are no longer a random sample of the trader’s orders. The orders that complete are disproportionately the ones the counterparty was happy to be on the other side of.

That skew has a measurable signature: the markout. Track the market’s drift in the seconds and minutes after each fill; under symmetric execution, post-fill drift should average near zero net of spread. A fill population that systematically drifts against the trader immediately after execution is the fingerprint of being the adversely selected party — selected into bad trades, filtered out of good ones. Measuring it requires no theory of intent, only timestamps: fills, quotes, and a reference feed. The Latency Arb Tracker we are building is intended to compute exactly those adverse-selection signatures from a trader’s own execution records.