Market making explained

Market Makers do their best work behind the scenes and are a key cog to ensure the crypto machine keeps on ticking. In this post we’ll expose the mystery of market making in 3 short steps

Market makers and liquidity providers are core infrastructure in all financial industries. Efficient Frontier builds technological systems to ensure capital is being deployed in the best manner. We are fortunate to work with some of the leading exchanges and tokens in the world in order to make their markets as attractive and tradeable as possible.

In the world of cryptocurrency the term ‘market maker’ has a mysterious and sometime ominous connotation. In this post we’re sharing as a public service a simple explanation of market making. We will debunk some common market making misconceptions and simplify some of the perplexing lingo.

What is a market maker?

The parable of the Nirvana fan at the record fair:

A Nirvana fan wants to open a stand at a record fair so other fans can buy and sell their vintage Nirvana records. He puts up a sign that says: “Trade Nirvana records here”.

As a fan he only has a few extra records he’s willing to sell from his collection, and he’s not willing to buy many records because he already has every Nirvana record he wants, including the rare editions.

Source: Reddit

This market will be disappointing: After he sells his handful of records, the stand will be empty. Then, the real chance to buy or sell a Nirvana record is if you hang out at the stand for the whole day and wait for the right person to show up, but even then the rare seller might try to jack up the prices, as the buyer may appear desperate.

Solution: The Nirvana fan invites a “record market maker”.

The record market maker has a large stash of Nirvana records and a lot of cash too, and he is always willing to buy and sell Nirvana records for the right price. He’s also willing to turn around and sell a record he just bought for a small profit.

Source: NYT

If a new Nirvana fan shows up with a lot of cash, he can reach into his record box and sell him as many Nirvana records as a fan would want.

If an old fan wants to unload his entire record collection he’s willing to buy it for a reasonable discount, and then is happy to offer it all back to the market.

The record market maker has literally created or made a market.

Without a market maker, the commerce at the record stand would be slow, volatile, less fairly priced and in other words inefficient or illiquid.

Capital markets market makers operate in a very similar way and serve the same function, providing a substantial percentage of the volume in any larger market in the world . The Nirvana record stand is an extreme example but makes the point. The market maker is almost always buying and selling, making the market more liquid and easy to interact with while turning a profit.

Three types of market makers

1. Voluntary: The market maker has a strategy that makes him a small profit on each unit he buys or sells. This can involve arbitrage (having a ‘runner’ go back and forth to the large record store downtown to benefit from price differences) and also by recognizing trends in the market ahead of others (The market maker’s employee detects a large group of grunge fans arriving at the fair so before they get to the stand he raised all the prices and brings out rare editions). The voluntary market maker uses his ability to predict short term price movements for his own profit and creates liquidity in the market as a byproduct.
2. Designated Market Making (DMM): The owner of the market place or token incentivizes the market maker either with fees per-trade, kickbacks or other benefits in return for providing liquidity to his market. Even if the market maker takes losses on some trades, the market maker will keep trading, as long as the market benefits. This market maker is focusing primarily on making the markets more liquid and efficient for other players to trade.
3. AMM (Automated market making) in DeFi: This new type of market making deserves its own post. We’ll just say here it’s nothing like traditional market making!

3) Maker and taker

In the world of market making, each order in an exchange has a taker and a maker

Taker: an active trader takes an existing offer (or bid) off the order book. This is considered a taker transaction or a ‘market order’. In layman’s terms, a buyer (or seller).

Maker: The other side of the Taker. The maker offers to buy or sell and his order sits patiently on the order book until someone takes it off the market. When taken, the exchange will execute the trade between the 2 parties. As the price of the asset moves, the market makers will algorithmically and automatically adjust the price of all the orders with the sentiment of the market.

Typically many of the maker offers are created by a market maker. Exchanges typically offer lower fees on maker transactions in order to incentivize a full order book of offers, making the market more liquid and attractive to traders.

Market Makers are critical in markets in order to ensure the markets are liquid and attractive for users and institutions to trade on. They ensure the following:

• Order books are filled on both the bid and the ask side, improving market depth.
• Spreads between the mid-price are optimized: The distance between best bid and best offer (bid/offer spread) is optimized. Without a market maker, spreads (and attractiveness of trading) are at the whims of organic buy vs sell pressure.
• There is sufficient capital sitting in the book so that if any person wants to trade a decent size of the asset, they will be able to.

The token brings the camel to water, and the market maker ensures there is an abundance of the freshest water to drink.

Thank you to Efficient Frontier’s trading team for their help in putting together this post.

If you are interested in hearing more please reach out to andrew@efrontier.io