This article was originally published on Hackernoon.
What is Market Making?
Market making is an activity whereby a trader simultaneously provides liquidity to both buyers and sellers in a financial market. Liquidity is the degree to which an asset can be quickly bought or sold without notably affecting the stability of its price. Market makers “make a market” by quoting prices to both buy and sell an asset. In this way, the market maker (or liquidity provider) acts as both a buyer and seller of last resort where there would not naturally be another buyer or seller, thereby providing liquidity.
Why do we need Market Makers?
Market makers enable financial markets to become more efficient because they reduce price volatility and assist with fair price discovery. This is how it works: For a given asset, the difference between the best bid and the best ask is called the bid-ask spread. Markets that have low liquidity will generally have wide bid-ask spreads in their order books. The size of the spread has a direct influence on the volume traded in the market, with a tighter spread generally resulting in more volume traded. A market maker does nothing more and nothing less than facilitating tight markets by posting tighter spreads.
Example 1 is a snapshot of a healthy market with a tight spread on Coinbase pro (BTC/USDC). The spread is 1 cent wide (0.0001%) for BTC, being valued at $11,025. Example 2 is from the OEX exchange (at the time of writing ranked no.10 in reported volume on Coin Market Cap) showing the cross EOS/USDT with a spread that is 62 cents (8%) wide on an asset worth $7.14 (EOS).
In addition to the bid-ask spread, another factor in determining an asset’s liquidity is the order book depth, which is the amount of an asset that can be purchased at a given price level. In the above example, a market participant could buy and sell several thousand dollars of BTC for an insignificant loss (.00001%). Whereas on EOS, if a trader bought and sold just a small amount of the token, they would immediately realize an 8% loss on their investment. If they wanted to buy and sell a few thousand dollars worth of EOS, i.e., going deeper down the order book, the loss would be magnitudes worse. As projects compete for the attention of institutional participants, this is a crucial metric to consider that has serious impact on a project’s viability.
Advantages for Tokens
At present, cryptocurrency markets suffer from a lack of efficiency. This creates a daunting environment for traders to participate in, where friction — the direct and indirect costs of transacting — is high. As a result, token issuers suffer, as they need a seller if someone wants to buy, and a buyer if someone wants to sell. In crypto, this isn’t always the case, especially for lesser-known tokens. Market makers alleviate the friction for individuals wanting to participate in the market, providing well-organized and cost-effective entry points for traders.
Facilitating Growth of the Token Ecosystem
For the majority of projects, the utility of their token is what drives their business model and future aspirations of adoption. The market maker ensures there is always a potential buyer and seller for the token, supporting healthy token economics and the project’s future growth. A token’s economic health, in turn, influences that project’s standing with key stakeholders in the crypto ecosystem, including exchanges, investors, and backers. Importantly, hiring a market maker to provide liquidity frees up token issuers to focus on building out their technology and driving adoption in the space.
Advantages for Exchanges
Price Discovery & Real Volume
The goal of the market maker is to provide liquidity, tighten the spread across trading pairs, and encourage order book volume. Ultimately, volume and exciting projects are what attract traders to an exchange. Unfortunately, many exchanges directly or indirectly endorse “fake volume” to entice projects and investors. The use of a reputable market maker can discourage volume manipulation while encouraging price discovery and order fulfillment. In turn, healthy order books increase investors’ level of confidence in the exchange, creating trust that is crucial in such a volatile space.
Concerns & Considerations
Unfortunately, some companies carry out questionable trading strategies under the guise of “market making”, which creates problematic situations for tokens. Market makers with no background in traditional financial products, for example, tend to over-promise and tie token issuers into questionable profit-sharing schemes. Others might promise price or volume targets, which is unethical, not to mention impossible to achieve in an efficient and orderly market. The choice of a market maker, therefore, is a crucial one, with the right partnership delivering lasting benefits to the overall project.
There are a few different business models that market makers might employ, each with important considerations for the token issuer:
Profit Loss (P/L) Model: Some market makers will attempt to make money off the token’s bid-ask spread, i.e., buying the token low and selling high. Increasing the spread increases income for the market maker, but reduces turnover (volume traded) for the given asset. The resulting bid-ask spread is larger than if the market making was aiming for maximum liquidity.
Retainer Model: In this case, market makers will aim to operate at a flat P/L and focus instead on increasing market turnover by offering tighter bid-ask spreads. The income is not generated from the spread, but rather as a periodic (e.g. monthly) retainer.
Profit-Sharing Model: Market makers adopting this model will typically attempt to make income from both the bid-ask spread as well as from a token loan which they trade for profit, often by manipulating the token price. While the gains might be shared, the losses are fully-borne by the token issuer. It should be noted that most reputable exchanges have rules against this type of arrangement, as it works against the retail investor and overall market health.
Note: unethical market makers often use wash trading (the act of buying and selling at the same price) to give the impression of increased volumes. The “fake volume” created is intended to falsely entice new investors by raising the token’s position in volume rankings. Wash trading is an illegal practice in traditional financial markets, and reputable players in the crypto industry are dedicating considerable efforts to uncover and obliterate this unsavoury practice.
Questions to ask your Market Maker
If you are a token project looking to engage a market maker, here are some basic questions that can help filter out bad actors and help you make a more informed decision:
Where are they trading from?
Market makers should be trading from their own accounts on the exchanges agreed upon with the token issuer. Some may suggest using the token project’s account on exchanges — do not do this. To comply with basic KYC and AML regulations and to prevent wash trading, market makers should operate with their own accounts, otherwise they can leave the project liable for malpractice.
What is the funding strategy?
Generally, a project will loan a market maker a supply of their tokens. This loan is usually a low-interest loan to be paid back in full after the length of the contract. The market maker will use this loan from their own accounts to “make the market”. Once the contract expires, the market maker will return the number of tokens loaned, not the original dollar value at the start of the contract.
Do they do profit sharing?
A token project should be wary of profit-sharing services. Some market makers will insist on some type of aggressive profit-sharing model — this is not market making. This type of strategy that manipulates the market gives no preference to the health and dynamics of the market and has asymmetric outcomes for the token issuer if things go wrong. Its sole purpose is to make money at the expense of the tokens’ community.
What are the KPIs and how will they be reported?
A market maker should have KPIs that include the bid-ask spread, percentage their orders are top-of-book (TOB), and order-book depth. A market maker should not be assessed on volume or price targets. If a market maker guarantees a price for an asset it is a clear red flag. In terms of reporting, market makers should strive for a high level of transparency in their trading, outlined in daily communication.
Financial markets need to operate efficiently, enabling investors and traders to buy and sell assets seamlessly and cost-effectively. Without market makers, there would be fewer transactions and the overall efficiency of markets would decrease. That is why the practice of market making has been an integral part of traditional market infrastructure, and its influence will continue as long as we trade financial assets.
Any institutional-grade market maker will operate with programmatic execution and algorithms that integrate with exchange APIs that are designed to create efficient markets. A robust API allows market makers to act more efficiently with more reliable up-times, providing consistent liquidity.
Like many aspects of the cryptocurrency market, standard practices need to improve and bad actors need to be stamped out. By quizzing market making partners on basic aspects such as trading strategy, funding, profit sharing, and KPIs, crypto projects will be able to find a reliable partner that works for them. An efficient market maker encourages a healthy token market, allowing projects to build the future of their digital asset ecosystem.
To learn more, contact firstname.lastname@example.org