A brief study on the solution to the NFT liquidity, Chapter III The Light — NFT market making
Some recent studies conclude that there are some issues in the NFT market, including low liquidity, high price volatility, and long potential holding times, which bring inventory risks and high potential search costs to NFT market participants (Kim et al., 2022). Therefore, NFT market making is relatively difficult in this less liquid market. As traditional market makers prefer to act as intermediaries to match demand and supply for illiquid assets (Dolgopolov, 2016), various NFT aggregators were regarded as “NFT market makers” and launched in the past several months. Although they facilitate information sharing and reduce information costs across different NFT marketplaces, they do not provide liquidity directly to the market as market makers. In order to explore the solutions to the issues in the NFT market, we need to understand more about market making as well as market makers.
1 The role of a market maker
A market maker is technically an institution that can maintain the double-auction order books for financial markets by actively posting and cancelling orders (Bloomenthal, 2021). In other words, market makers provide liquidity and depth to markets. In the crypto market, the majority of market makers are often large institutions in an effort to keep various crypto assets liquid.
Market makers usually post buy and sell orders in a range and wait passively for other participants to take them, which facilitates a smoother execution of the entire order flow. Their actions may be strategic, in which the buy or sell orders are placed or cancelled according to certain speculative motivations, optimized inventory control, or business obligations. For the sake of liquidity quality, market makers are usually algorithmic traders who trade through sophisticated computer programs and high-speed networks and maintain a disciplined trading culture in the impulsive and volatile crypto market. By taking the risk of their crypto asset inventories, market makers basically profit from the spread, i.e., the difference between the best bid and offer prices. Through high trading volumes and optimized actions, market making may be profitable in a sustainable way.
Market makers provide their services with varied motivations, among which Designated Market Makers (DMM) is a particular group. DMMs are often premium trading institutions shortlisted by exchanges or projects of crypto assets, and they work closely with them to maintain the activeness, volumes, and efficiency of trading and to provide a high-quality experience to the common market participants. There is no doubt that DMMs are one of the cornerstones of the whole crypto community.
2 The status quo of NFT market making
Currently in the NFT market, mostly speculators are providing liquidity, and they have to be extremely patient to trade on NFT aggregators or on Opensea, Looksrare, and X2Y2, especially for blue-chip NFTs. In this case, some holders tend to use NFT fractionalisation tools or P2P lending protocols to cash out as quickly as possible by taking the risk of losing the original assets. Others may choose P2Pool lending protocols or the emerging NFT AMMs to realise their NFT assets at a discount. Basically, it is difficult to effectively and efficiently trade blue-chip NFTs at a fair price and with low risk due to an NFT trading trilemma appearing on the existing trading platforms, aggregators, and liquidity solutions. As can be seen from the trading volume, only some top trending NFTs may have sufficient liquidity in a short period while most other NFTs are dead as soft rugs. We believe these NFT project teams have no clue how to deal with such an NFT liquidity issue, even if they would like to go for the long run. To solve the issue, apart from improving NFT trading tools, introducing market making may also help.
Actually, there are developers trying to solve the liquidity issue with their own NFT market making solutions. In the past several weeks, emerging NFT AMMs have brought a steep and rapid increase in NFT trading volume in a short period. But with a similarly steep and rapid drop coming afterward, some drawbacks of NFT AMMs are disclosed. Although trading against pools is efficient as no direct counterparty is needed, the relatively high unit price remains the same, in which a large number of retail traders still cannot accept the volatility of the NFT market and take the risks, especially for blue-chip NFTs. Besides, due to the limited depth in each pool, a relatively high level of slippage in each transaction cannot be avoided. In other words, NFT AMMs increase liquidity to some degree but bring new issues.
In this case, we are wondering if it is possible to increase NFT liquidity with traditional market making strategies. The answer is yes, but exceptionally difficult. Most of the market making strategies are not working for non-standard assets due to their restricted price precision and inadequate price discovery. In general, the uniqueness of NFTs creates a price gap even within the same collection, which obstructs the continuous quotations from market makers and leads to the current inadequate price discovery. Besides, most NFTs are ERC721 tokens traded as a whole asset, in which the price precision is not as flexible as fungible tokens. As a consequence, market makers cannot confirm the sufficient buy and sell spread along with trading volume and frequency to make profits. In order to provide NFT liquidity, a market maker would thus face high inventory risk and put up with low utilisation of funds. In one word, all these issues, coupled with the lack of appropriate NFT trading and hedging tools, limit market makers’ performance and revenue.
3 A potential solution
In summary, with the aforementioned risks and difficulties, market makers cannot provide liquidity and facilitate smooth trading by actively listing buy and sell orders on current NFT marketplaces. Actually, market making activity is terribly limited. Only a few market makers are making profits on- and off-chain by taking the high risk of holding NFT assets for a significant time period. By reviewing the NFT liquidity issue, we can humbly say that DMMs would increase the liquidity of specific NFT collections, and can potentially solve the liquidity issue.
As a type of crypto asset, NFTs also need market making to have sufficient liquidity and more trading activity. Similar to many crypto exchanges and projects, NFT marketplaces and projects should work with DMMs who can operate and compete with each other to attract NFT investors, collectors, retail traders, and DAOs by setting the most competitive bid and offer. As mentioned before, market makers have to bear the risk of covering a given asset, which may drop in price. Therefore, if DMMs are compensated for this risk of holding NFTs, they will ensure that all marketable trades are executed at a fair price in a timely manner.
Apart from an improved trading experience, NFT market participants are also looking for a new NFT trading protocol to provide a more transparent trading environment with lower fees, and to suit market making strategies. Thus, we can expect a more efficient NFT market in the near future.
Reference
Bloomenthal, Andrew. “Market Maker Definition: What It Means and How They Make Money.” Investopedia, Investopedia, 31 Aug. 2021, www.investopedia.com/terms/m/marketmaker.asp. Accessed 20 Oct. 2022.
Kim, Jack, et al. “Market Making in NFTs.” SSRN, 22 Sept. 2022, deliverypdf.ssrn.com/delivery.php?ID=422073103008120080104121081072003088050013055019019054113026091123111084098124116089026006024040028056016078098115002076125116061043059044028070098097100103109115015025022043090067000015094101114094072081002094122084067065077120115091117120018013022074&EXT=pdf&INDEX=TRUE. Accessed 1 Oct. 2022.
Dolgopolov, Stanislav. “Regulating Merchants of Liquidity: Market Making from Crowded Floors to High-Frequency Trading.” SSRN, vol. 18, no. 3, 17 July 2016, pp. 651–732, papers.ssrn.com/sol3/papers.cfm?abstract_id=2677087. Accessed 2 Oct. 2022.
By Jason Liu & Lizzie Lu
About ZMQ
ZMQ is a Leading Global Quantitative Market Maker and liquidity provider in Digital Assets. Since jumping into the crypto market in 2018, ZMQ has been focusing on providing liquidity globally for token projects and exchanges, institutional crypto investments and consulting services to bring better price discovery, trading executions, transparency to investors and efficient pricing to the market.
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