Creating liquidity: Attracting crypto market markets

What are the best practices for incentivizing liquidity providers to allocate recourse to a cryptocurrency exchange? Efficient Frontier shares insights from trading algorithmically 24/7/365 in over 40 cryptocurrency exchanges

As leading cryptocurrency algo-trader, Efficient Frontier trades spot and derivative across the entire cryptocurrency ecosystem. Our end goal is always to increase the liquidity and quality of the markets. We strongly believe in encouraging high industry standards which will increase the success of the cryptocurrency markets as a whole. As par of this effort we’re presenting the following articles.

Every year more cryptocurrency exchanges are founded. There’s almost no limit to the amount of work and capital a firm can put into providing liquidity to an exchange, but in practice, market makers need to decide how much additional capital, operations, and R&D resources they allocate to each venue.

As in traditional markets, cryptocurrency exchanges create agreements with market makers in order to build liquidity and attract traders. The following factors influence our decisions in allocating capital and developer hours to exchanges as part of our market making programs.

We’ll describe below these general market making frameworks and best practices we suggest in order to help build more effective and efficient liquidity strategies: Technical standards, correct incentives and quantifiable trust. These frameworks are likely similar for other experienced and reputable market making firms.

Technical standards

The assessment of our engineering team is key in deciding how much time and resources to allocate to an exchange. These technical factors are beyond the scope of this article but fall into two main categories:

1. Simple integration, documentation and responsive support.
2. Solid infrastructure: minimal bugs, latency and errors in the exchange or the API.

Smart incentive programs

A popular method in drawing designated market makers is setting predefined KPIs the market maker needs to meet in order to get a retainer and other incentives. The most important KPIs are:

• Spread (prices)
• Slippage (liquidity/capital)
• Uptime (availability)

Additional performance metrics are:

• Trade volume KPI — Getting incentives for generating trade volume in absolute numbers (can be maker, taker or both — not wash trading)
• Getting incentives for generating a specific percentage share of the overall exchange volume (this will typically be a bonus and not a stand alone)

Some flexibility is useful: A designated market maker — which is required to stand within specific and rigid KPIs — is inherently sub optimal for generating profit. The best designated market makers will have strategies that generate some profit and allow them more flexibility to invest back into the exchange by quoting tighter spreads or injecting more liquidity at a time and generally trading more.

Opportunity to generate a minimum revenue: Either from trading, retainer, rebates or a combination of all.

Clarity is important: Too many exchanges modify their ‘Designated Market Maker’ (DMM) programs too rapidly. This creates uncertainty for DMMs, which in turn leads to lower focus and research resources dedicated to the exchange and lower chances of performance growth. We recommend building and budgeting a 6 month plan with clear terms.

Dislike of equity incentives: Either compensation in the exchange’s token or traditional equity tend to be less attractive since typically this will be a very minimal amount which the MM will need to manage and handle and won’t know the true value or when they’ll be able to exit their position. MMs generally prefer stability over opportunity in these cases. There are of course exceptions to this general rule depending on the exchange.

In the next post we will write about what to except from a market maker and how to quantify their performance.

Quantifiable trust

Becoming a successful cryptocurrency exchange involves a very high level of trust. This is due to the cash-like nature of cryptocurrency and is magnified by the current shortage of legal clarity. This environment leads to risk averse decision making when it comes to deploying money to a new exchange. Before considering potential profits, the marker maker needs to be confident his funds and work will not be lost or compromised. Anything that can deliver this trust is worth presenting.

Security and responsibility over capital deployed

Market makers need to know their funds are secured and that the exchange is taking responsibility over securing and compensating in case of errors, fraud, thefts, etc. on the exchange side.

Technological reliability

A reliable infrastructure will provide the professional traders the assurance they need in order to trust the exchange and invest research into it. A troublesome exchange will do the opposite. It’s also highly important to leave enough time for beta testing a new exchange, to have the capacity to fix issues quickly and generally follow best practices.

Providing access to current and previous activity on the exchange

(this is very important but for newly launched venues is less relevant)

1. Trading volume data
2. Market participants (how many; is trade concentrated in the hands of a few or more evenly spread out; etc.)
3. Order book status (slippage, spreads, consistency, level 1 and level 2 historical data)
4. Market surveillance (against spoofing, wash trading etc.)

Trusting new exchanges

For newly launched exchanges, the risk to capital is greater for various reasons. We have seen a few cases with some very troubling occurrences with newly launched exchanges:

Major risks factors:

• Security systems have a limited history in handling funds, and even then typically with limited amounts.
• The matching engine, leverage and other risk management systems are young and behave immaturely.
• API connectivity issues which lead to trading errors, which can cause losses

Communicating issues openly and in advance can help.

Other trust building factors

• Compliance with regulations, KYC, and legal handling
• Legal agreement wording and process — should be clear, fair and simple.
• The team’s background
• Funding status and partners/investors
• The belief that the exchange is going to grow and be a long lasting partner

Tips to ease the minds of the market maker’s risk manager

• Ensure and be able to demonstrate the strength of your security system and process
• Take responsibility for funds in case of loss due to system malfunction, theft or error.
• Use third party solutions like Fireblocks and Copper to allow players to control and move funds more securely
• Provide assets or credit lines on the exchange instead of requiring capital where possible.

In the next post we’ll share our insights on what to expect from a cryptocurrency market maker and how to measure its performance

*This article is an abridged version of a document we share with prospective clients and partners

Want to work at Efficient Frontier? We’re hiring.