Order Flow Toxicity and Adverse Selection
Some traders know more than those quoting to them. How liquidity providers measure informed flow, and why it drives spreads and depth.
A market maker earns the spread on average but loses when trading against participants who have better information about where price is heading. This cost — adverse selection — is one of the core forces setting the width of spreads in every electronic market.
Measuring toxicity
- Markouts: the change in mid-price at fixed intervals after each fill, from the liquidity provider’s perspective.
- Order-flow imbalance: sustained one-sided aggressive flow over short windows.
- Volume-synchronized measures such as VPIN, which estimate imbalance in volume-time rather than clock-time.
Consequences for liquidity
When liquidity providers detect rising toxicity, the rational response is to quote wider, show less size, or step back entirely. This is why liquidity often deteriorates just before or during large moves: the flow that precedes them is, by definition, informed.
For institutional traders the implication runs the other way: flow that is persistently identified as toxic will face worse prices over time. Execution that disguises urgency and avoids predictable patterns preserves access to better liquidity.
This publication is provided for informational purposes only and does not constitute investment, legal, or tax advice, or an offer or solicitation to buy or sell any asset. Live figures are computed from third-party public market data and may be delayed, incomplete, or inaccurate.
