Hillrise Research
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Hillrise Research

Market Making Primer

By Daniel Dal Bello, Director.
February 5, 2021–7 min read.

One of the most critical components of a successful token market for a crypto-startup is liquidity and with liquidity comes market makers. So who are these market makers and what do they do?

These firms are of the most important long-term partners for any startup with a token and secondary market. A healthy trading environment has order book depth, tight spreads, and organic liquidity — market makers help to facilitate this environment.

In this post we will take a closer look at what market makers do, the value they provide to the market and to their clients, some common misconceptions, and how automated market makers and high-frequency trading impact the market.

In this post, we present our version of a market making primer.

Market-making is a necessary yet relatively unexplored service area for the average participant in the blockchain industry. However, and in contrast, marketing, PR, and community management are well-known.

Services that market makers provide can be discussed in two parts — one technical and another enriching.

Let’s start with the technical offering. Market makers do just what the name suggests — they make markets. An illiquid market has several clear indicators of just that: low volume, a fragmented order book, cross-exchange mispricing (if relevant) and a significant bid/ask spread.

Volume is a term that almost any crypto-market participant is aware of. It is simply a fiat-denominated value to indicate how much money has changed hands — typically expressed over a 24 hour period. If a token-market has strong volume, this generally gives a positive impression and encourages participation.

Spread you might also be familiar with. The spread indicates the difference between the highest buy offer (bid) and lowest sell offer (ask). When there is no market-making, and it’s only (retail) traders buying and selling a token you will notice that the spread can be large as there will mostly be buy and sell orders around major resistance and support levels. By virtue of this spread, larger orders are also more likely to make a bigger impact on price when executed.

This is where a market maker comes in to dynamically adjust and manage the bid/offer spread. Regular traders (mostly) manually execute their trades, and market makers use algorithms to deploy reactive repositioning and minimize the spread.

Typically proprietary algorithms are constantly calculating how to best set both bid and ask orders so that traders can get the best prices for their tokens while also making sure that large block trades have a minimal negative impact on the market — softening the blow when it comes to large trades (essentially balancing the market). The algorithms usually also take broader macro-market movements in Bitcoin and Ethereum into account — especially if these assets are the other side of the market pairing — to manage volatility.

Wikipedia, the bid-ask spread.

Order book depth is another critical component of the technical offering. Increasing depth through ‘ladders’ of liquidity in the orderbook decreases volatility in both directions and generally increases confidence in the market itself.

When relevant, cross-pair or cross-exchange arbitrage becomes important where there are multiple pairings or exchanges where the token is trading. Managing price discrepancies across markets is important and can be a source of arbitrage profit for the market-maker and potentially the client — depending on their relationship.

It goes without saying that market presence and uptime is generally a critical KPI as any downtime can be detrimental to the market and cause temporary spikes of volatility.

Treasury re-balancing ensures that the inventory available to the market-maker team to manage the market remains in a positive position. For example, having $1,000 USDT and $100,000 in a token is restrictive and difficult to manage. Ideally, this ratio would be closer to 50:50.

Now we have introduced the core technical components of the typical market-maker offering, let’s go through some of the more bespoke services that really separate one firm from another.

Treasury management is a service that not all market makers provide — for many reasons — mostly due to custody, regulation, and risk. A typical treasury management service would involve active management of a startup’s treasury and deploying a market-neutral or directionally-agnostic algorithm to profit from market volatility — the goal being to slowly grow the client treasury over time.

A liquidation service is a common and highly valuable additional service that allows clients to realize operating capital by selling their asset while minimizing any negative impact on the market — this is typically through something called clustered dust orders or dust-selling.

Team tokens are there to be used for operations. They are expected to be sold at some point to ensure that the team has the cash to pay for operating expenses, salaries, marketing, ecosystem incentives (e.g. signing on partners), and more. This becomes especially relevant in recent times where raises are becoming smaller, and team token shares larger — it’s crucial to be able to realize this value without negatively impacting the token market.

In contrast, manually selling tokens is cumbersome, time-consuming and most likely will have a negative impact on the market. Market makers can use these tokens to create liquidity, which in return leads to funds which can then be made available to the client.

Exchange strategy is a commonly overlooked value-add that can be an extremely important part of a market-making relationship. Maker-makers have undoubtedly some of the strongest relationships with centralized exchanges in the industry. They make x number of markets and y dollars of volume — giving them a significant level of influence on introductions and negotiations.

Note: Some market makers have specific markets they prefer and might even work for, so it’s always important to consider the underlying motivations for an introduction to one exchange over another.

Although cryptocurrency investors tend to think that market makers play a large role in manipulating token prices — this is often not the case. Most market makers are fully compliant and regulated in their jurisdiction.

Consulting and token design is another area many larger firms are willing and able to provide depending on a prospective client's timeline. If the client is pre-launch, market makers typically have a wealth of data which they can leverage to advise on token design and ‘tokenomics’.

Dashboards and bots are other areas where firms can differentiate themselves. Most firms typically offer a real-time Telegram bot to query balances, market participation, inventory levels, profit and loss, etc. Some firms might even have custom web-based dashboards to login and review this information.

Communication and reporting are the final pieces of the puzzle for a full-service offering. Market makers will generally agree to fortnightly or monthly calls alongside detailed reporting for insight into their performance, KPI targets, and general market intelligence.

So how about Uniswap? Do we even need market makers anymore?

Recent advancement in decentralized finance has brought with it a new and innovative way to manage liquidity in the token markets — Automated Market Makers (‘AMM’).

Automated market-making refers to the use of smart contracts for price discovery without human intervention. AMMs rely on a set of rules determined by an underlying smart contract. To give an example, for Uniswap — the most prominent AMM to date — a standard equation of k=x*y is used for the price.

Cyrus Younessi, Scalar.

With an AMM, there is no manipulation of the price possible besides buying and selling. This is due to the ‘Liquidity’ that is pooled in a liquidity pool. There are no buy and sell walls that move around, just a set formula that balances the tokens in the pool.

Besides the aforementioned formula of Uniswap, there are multiple AMMs with different formulas. Mooniswap, for example, takes slippage into account and distributes part of that back to the liquidity providers, resulting in higher yield.

So with this autonomy, are market makers obsolete in the DEX markets? In short, no.

Traditional market makers can still help to manage the liquidity balances in DEX markets on behalf of clients. Besides this and by virtue of DEX markets being on-chain, valuable data can be gathered by market-making firms managing these token markets.

Top firms have very sophisticated software to gather data points or ‘wallet analytics’ which can be extremely valuable in evaluating average purchase prices, likely points of buy and sell pressure, and other token holder data.

Engaging a suitable market maker is one of the most important choices a new blockchain startup faces. Market makers should be long term partners, so it pays to evaluate the market thoroughly.

While we don’t typically hear much from these firms, they are critical players, facilitating the liquid markets investors need.

Hillrise Group supports ambitious Web3 startups with early-stage venture capital and fundamental research.

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