A A Practical Liquidity-Sensitive Automated Market Maker

Automated market makers are algorithmic agents that enable participation and information elicitation in electronic markets. They have been widely and successfully applied in artificial-money settings, like some Internet prediction markets. Automated market makers from the literature suffer from two problems that contribute to their impracticality and impair their use beyond artificial-money settings: first, they are unable to adapt to liquidity, so that trades cause prices to move the same amount in both heavilyand lightly-traded markets, and second, in typical circumstances, they run at a deficit. In this paper, we construct a market maker that is both sensitive to liquidity and can run at a profit. Our market maker has bounded loss for any initial level of liquidity and, as the initial level of liquidity approaches zero, worst-case loss approaches zero. For any level of initial liquidity we can establish a boundary in market state space such that, if the market terminates within that boundary, the market maker books a profit regardless of the realized outcome.