Efficient Frontier
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Efficient Frontier

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

What is a market maker?

Source: Reddit
Source: NYT

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

  • 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.

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Sarah Wiesner

follow me on twitter @internethello @bitcoinembassy @efrontier_io