Adverse Selection
Adverse selection is the expected loss a liquidity provider takes when the other side is informed — the Glosten–Milgrom reason spreads exist even with no inventory.
Definition
A maker who is picked off after a trade sees the mid run away. That markout is adverse selection. Glosten–Milgrom show that even risk-neutral market makers must widen quotes when the probability of informed flow rises.
Why it matters
PFOF, maker-taker, and “toxic flow” debates are adverse-selection debates. If you cannot measure markouts by horizon, you cannot price liquidity.
Case
A quote that is filled and then the name gaps 40 bps against you in 2 seconds was selected. A fill that mean-reverts was not. Averaging them into “spread captured” hides the book.
How to read it
Report signed markout at 1s / 10s / 1m / 10m. Short-horizon toxicity and long-horizon drift are different objects.
Key papers
- Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed TradersGlosten, Milgrom · 1985 · Journal of Financial EconomicsAdverse-selection spread.