The Market Maker’s Guide to Decentralized Exchange
We’re creating a platform for market makers, and working with advisor Michael Novogratz and Galaxy to provide liquidity to decentralized exchanges.
I spent a quarter of my life as a trader at Virtu, one of the premier algorithmic market makers in the world that went public in 2015 for $2.5b. As an electronic market maker in a time of technological revolution, we saw computers de-facto replace human traders on Wall Street.
A market maker is a party that provides bids and asks in a given instrument at all times, and forms what is called the bid-ask spread. They are willing to buy and sell an asset at all times, and their buy and sell prices are reflected on a given exchange.
Throughout the last month, we have worked on the trade floor at Novo’s new cryptofund, Galaxy. Together with Galaxy we have helped frame how a liquidity provider will behave and operate on AirSwap and other decentralized exchanges.
What does it take to be a liquidity provider?
- Technology
- Experience (know-how)
- Balance sheet / risk tolerance
Components of a Market Maker
Market making is generally an ongoing process that includes ingesting data, generating a price, and placing an order on an exchange.
The map above shows how a user can build a market maker that brings liquidity from centralized exchanges to decentralized exchanges.
Opening a global marketplace
Decentralized exchange promises two major benefits:
Security and control
This is a commonly discussed benefit to decentralized exchange. Users always have control over their information and assets. Centralized exchange hacks have been covered extensively.
Global marketplace
Surprisingly, this is often overlooked. Centralized exchanges are local. Decentralized exchanges, if designed correctly, allow for a global marketplace to emerge.
Digital currencies are the first global asset classes, as anyone in the world can buy and transfer them with the click of a button. I attribute the recent crypto price surge at least partly to that fact.
Unlocking the ability to transact globally, through a decentralized exchange, will affect society in profound ways. Global information transfer birthed the term “globalization”. Global asset transfer will birth some new term that we all haven’t yet thought of, and in the end the borders that blockchain break down will be greater than the borders we saw the internet break down.
In this case, we have 3 market makers M1, M2, and M3.
- M1 is connected to exchange 1
- M2 is connected, and arbitraging the price from exchange 1 to exchange 2
- M3 is connected to exchange 3
The Taker T is only connected to Exchange 2.
There are 3 open bids:
- M1 wants to buy at 10
- M2 wants to buy at 9
- M3 wants to buy at 11
Note that M2 is arbitraging the bid from Exchange 1 to Exchange 2.
The Taker will sell at the price of 9. If the taker wants to sell, they only see the bid at 9, and therefore receive a delta of 2 from where the global price is located.
In this example, each exchange is acting as it’s own matching engine and clearing house. These pools of liquidity are segregated, which is unnecessary and inefficient. These issues are prevalent in all centralized exchanges, and also apparent in some decentralized exchange designs.
In this case,
- M1 wants to buy at 10
- M2 wants to buy at 9
- M3 wants to buy at 11
The Taker will sell at a price of 11. If the taker wants to sell, they see the global price of 11 as they are connected to a single network of market makers.
Designing an exchange for market makers
There are many mature centralized exchange options that offer high liquidity and usability. Decentralized exchanges will succeed, likewise, when there is liquidity and usability, both of which do not exist yet on any solution. So what does it take to build liquidity from market makers?
Secure — Market makers must be able to operate on an exchange that does not present an ongoing threat to its assets, whether by hackers or exchange operators.
Global — Giving market makers access to a global trading network maximizes the likelihood that they’ll connect with a taker and be able to make trades.
Free to place and cancel orders — Operating a market maker is often a process of placing and canceling orders. Unless this activity is free, these fees add up quickly.
Free of exchange fees — Different exchanges have different fee structures. On Wall Street, it’s free to place and cancel orders, but actually executing the order incurs a fee.
No front running — Front running is for an exchange operator or miner to place an order ahead of yours, effectively taking advantage of insider information.
Low latency — The speed at which orders clear is a factor, and one that technological solutions are consistently improving on.
Free of race conditions — If a market maker is prepared to cancel an order, whether due to stale pricing or a change in strategy, it should cancel predictably. The expectation of predictability also applies to market takers trying to fill an order.
The more efficient the market is, the tighter the market maker’s bid/ask spread will be. The tighter the bid/ask spread, the better it is for traders that wish to take liquidity on that market.
A decentralized exchange will succeed when bid/ask spreads are tight enough to compete with their centralized competitors.
Peer-to-peer is the Market Maker’s choice
Our peer-to-peer design provides the benefits of decentralized exchange, without the cost and limitations of operating on other centralized and decentralized designs.
The less friction, the better the platform for market makers, and the tighter the bid/ask spread.
Here is a sneak peak at the Maker dashboard we are building:
We are working with Michael Novogratz and Galaxy to onboard the first market maker for decentralized exchanges.
2018 will be the year of decentralized non-custodial P2P protocols. The hardware and software risks with other systems is high and the barriers reduced by DEX are significant. If you are a protocol developer or blockchain developer, feel free to drop us a line at jobs@airswap.io
