Liquidity Providers
This is the third part of a series on the fundamentals of cryptocurrency exchanges. This article focuses on the market maker, what motivates them, and why they are important for the marketplace and, by extension, cryptocurrency exchanges. Terms in bold were previously defined here and here. Otherwise, they are explained in the article.
Exchanges are marketplaces. They just intercede between buyers and sellers to facilitate transactions. In order to exist, marketplaces need people with an inventory of things to trade. These people are called market makers. These market makers set prices on the inventory that they have for trade.
Similarly, cryptocurrency exchanges also need market makers to exist. The cryptocurrency world uses different nomenclature for the same phenomena encountered in more familiar marketplaces. For example, things for trade are called assets, market makers are referred to as liquidity providers, and orders are filled (or fulfilled) when an exchange helps to facilitate a transaction.
Consider a smelly example. A traditional Korean dry foods market will have vendors selling dried squid. These vendors will also buy dried squid if they anticipate being able to sell it later for a profit. Dried squid is the asset in this example.
Liquidity providers make money buying an asset at certain a price and selling it later for a higher price. The purchase price is called the bid price. The sale price is called the ask price. The difference between the maker’s bid and the ask price is called the bid/ask spread. In the smelly example, dried squid vendors are liquidity providers and they profit from the bid/ask spread.
In a cryptocurrency exchange, liquidity providers enter their ask and/or bid prices in the exchange’s centralized order book. In this order book, ideally, many other liquidity providers are simultaneously listing their ask and/or bid prices.
Generally, the greater the number of limit orders in the centralized order book, the better the market liquidity of the exchange. Exchanges need liquidity providers in order to improve market liquidity. Market liquidity, also called asset liquidity, is an indication of how favorable it is to buy or sell an asset at any particular point in time. It is a function of the number of limit orders in the centralized order book and the size of the bid/ask spread.
Market liquidity is the reason it may be more favorable to purchase dried squid at a dried foods market with hundreds of dried squid vendors fiercely competing against each other than it is to make the purchase in a market with just a couple of vendors.
Reductions in market liquidity are not desirable. Imagine that a live octopus craze sweeps through Korea. For weeks, people only purchase and consume live octopus, called sannakji [산낙지] in Korea. The craze results in fewer people having interest in dried squid. The market interest is low. Like dried squid, its market liquidity dries up. The market for dried squid becomes an illiquid market. Fewer people pass through an illiquid market.
In illiquid markets, the time between transactions increases in comparison to highly liquid markets. Consequently, in an illiquid market, market makers holding inventories of dried squid, either have to sit on their inventory for longer periods or complete transactions at prices that are unfavorable to them.
Market makers do not want to trade at prices that are unfavorable to them. Cryptocurrency exchanges know that there are risks to being a liquidity provider when there is a shortage of takers. When there are fewer takers in the marketplace, makers risk unprofitably holding inventory. For this reason, cryptocurrency exchanges offer incentives to liquidity providers. For example, GDAX eliminates transaction fees on all limit orders.
Cryptocurrency exchanges will go to even greater extents to attain substantial order book depth and generate trading volume by paying liquidity providers fixed service fees for specified spreads and volumes. For example, HitBTC pays liquidity providers 0.01%.
Additionally, cryptocurrency exchanges may set aside a portion of their own funds to provide liquidity themselves. Ideally, cryptocurrency exchanges do not need to resort to using their own inventory of asset to fulfill market orders. Ideally, liquidity providers do just that.
Please note that a limit order that is immediately filled is does not add to the market liquidity of an exchange.
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