Liquidity is the lifeblood of any trading venue, whether traditional or crypto. Without liquidity, exchanges are just useless pieces of software, having nothing in common with a profitable business.
The driving force behind liquidity in trading is market makers — professional, sophisticated guys who make trading alive.
In this article, I will walk through market making in crypto, how it differs from traditional one, what strategies it applies, as well as its risks and incentives.
Let’s get started.
Who are Market Makers, and what do they do?
A market maker (MM) is a professional trader who actively quotes two-sided markets in a particular asset, providing bids and asks along with the market size of each.
Market makers provide liquidity and depth to markets and profit from the difference in the bid-ask spread.
Market makers can be institutional traders (a bank, trading firm, broker, or brokerage house) or individuals.
In most cases, MMs
Often, market makers are hired by exchanges to provide liquidity on particular assets and maintain the market in a good state.
Essentially, they undertake to:
- Quote bid-ask assets prices throughout the day
- Maintain the spreads below a maximum limit
- Maintain minimum depth
- Maintain orders for a minimum time limit (the uptime requirement), etc.
In other scenarios, market makers might have no collaborations with exchanges and trade in their own interests.
Specifics of Crypto Market Making
Though market makers in both traditional and crypto markets perform the same function of providing liquidity, there are some critical differences between them.
The main difference is that the crypto market is still a wild run: exchanges are not safe both from technical and regulatory standpoints, assets prices insanely volatile, “wash trades” are a common practice, and none of the fundamental or technical analyses is sufficient to rely on. Though the crypto market has impressively progressed so far, playing on it still feels like a ride with a blind driver. It implies way more “hidden gems” than its traditional counterparty.
Other specifics of crypto trading:
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relatively low liquidity of assets,
-
significant risk of
slippage , -
ease of price manipulation,
-
high probability of
flash crashes when large orders come into place, and the like.
On the positive side, in crypto, the entry barriers are way lower for MMs than in traditional markets. Also, MMs are usually free of maker’s fee payment and even incentivized with rebates — a certain percentage of the trading fee that the liquidity taker pays.
Typical crypto market makers are brokerage houses, hedge funds, or private firms with sufficient resources and expertise.
Market Makers vs. Automated Market Makers
Though they sound similar, market makers and automated market makers (AMMs) are entirely different entities.
As mentioned above, MMs are professional traders (an individual or a legal entity like a broker firm), often operate under a special license, provide liquidity to markets, and earn on bid-ask spreads.
On the other hand, AMMs are a type of decentralized exchange (DEX) protocol that relies on a mathematical formula to price assets. Instead of using an order book like a traditional exchange, assets are priced according to a particular pricing algorithm.
For example,
x * y = k
where x and y are amounts of two assets in the liquidity pool, y is the amount of the other, and k is a fixed constant, meaning the pool’s total liquidity always has to remain the same.
An AMM’s work looks like this:
a liquidity pool provides liquidity to an AMM. Once the liquidity is added, trades are carried out according to the established pricing algorithm. Every trade (or a swap) is charged with a fee (typically 1%-1.5%), which would be later paid out to the liquidity providers proportionally to their contribution to the liquidity pool.
Unlike AMMs, MMs are not restricted to the price curve and maintain their own spreads. Regular market making involves more active participation as compared to AMMs.
How do Crypto Market Makers make money?
As mentioned earlier, crypto market making is a tremendously risky activity. So how does it pay off? What is the incentive behind it? The answer is spread.
Market makers take small profits in the amount equal to bid-ask spreads with each trade while dealing with massive trading volumes.
At the end of the day, market makers would have thousands or even millions of such trades executed and, therefore, an impressive overall profit.
Let’s take a look at an example of orders from a market maker:
- Buy-order for 1000 units at $1
- Sell-order for 1000 units at $1.02
- The spread is $ 0.02
Total profit made by trading 1000 units: $20.
Crypto Market Making strategies
I’ll just briefly walk through them here:
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Delta Neutral Market Making
A market maker seeks to self-hedge against the inventory risk (see below) and wants to offload it in another trading venue. For that, a MM would place limit orders on an exchange with low liquidity, and when those are filled, immediately send a market order (on the opposite side) to exchange with higher liquidity.
So, if a MM bought inventory on one exchange, then they would sell it on another. In this case, our MM would have open positions on both exchanges, they sum to zero, and there’s no outright position (gains on one exchange offset the losses on the other). The price the MM would offer on the low liquidity exchange would be the cost of filling the market order on the higher liquidity exchange, plus a small profit.
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High-frequency “at the touch” Market Making
In
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Grid Market Making
In this case, a market maker places limit orders throughout the book, of increasing size, around a moving average of the price, and then leaves them there.
The idea is that the price will ‘walk through’ the orders throughout the day, earning the spreads between buys and sells.
Key risks and hurdles of Crypto Market Making
(i) The inventory risk
The most painful risk of market making is known as the inventory risk.
Inventory means a particular amount of assets a market maker has to store to be able to fill a buy/sell order.
The inventory risk shows up each time when a price of an asset starts moving with a trend. In other words, instead of fluctuating sporadically, which is probably the best-case scenario for a MM, the price begins consistently going in a particular direction.
Let’s say an asset price starts to trend downward. So what happens for a MM here while they act on both buy and sell sides for this asset? Right! Their buy-orders will start to be filled, while the sell orders won’t. To handle this situation, our MM would increase the inventory of the asset that is losing value, resulting in total inventory value will decrease over time.
Sooner or later, the price could get back to a profitable level, and the market maker would be able to sell his inventory with plus. However, if the situation with price dropping keeps going, the MM’s inventory would be locked on one side.
At the end of the day, the market maker would be forced to stop his operation and wait for better prices or start selling his inventory at a loss to keep his operation going.
So summing up, the inventory risk is the probability a market maker can’t find buyers for his inventory, resulting in the risk of holding more of an asset at the wrong time. Another scenario is when a market maker has to sell assets too early while their prices are rising.
The inventory risk is inevitable in any market-making, whether it’s done on the traditional or crypto markets. However, its probability dramatically increases when it comes to crypto, as crypto assets are way more volatile than their conventional alternatives.
(ii) Other concerns and bottlenecks
Non-regulated status of exchanges
Most cryptocurrency exchanges operate off-shore and therefore sidestep the supervision of a regulatory watchdog. Therefore a market maker needs to be extra cautious while considering professional engaging with a particular crypto exchange.
Security issue
Cryptocurrencies are often exposed to exploits and hacks. Therefore security has always been a number one concern for all types of crypto traders.
Latency issue
Latency means a delay in data transmission. For market-making efficiency, latency shall be as low as possible. In other words, a maker needs to get quick responses from their clients with trades on both sides of an execution price. A proven way to achieve this is by collocating the market-maker’s servers with those of a cryptocurrency exchange a maker works with. However, not all crypto exchanges offer such an option for market makers, and reaching the right latency can be an issue for market makers.
Cost of market-making software development
It’s just huge. However, there are a lot of off-the-shelf software solutions that could help make the process slightly cheaper.
Lack of standardization
Unlike traditional financial markets, there are no standard protocols for crypto exchanges. Thus it can require extra effort to adjust to an exchange’s API. Plus, APIs sometimes can have some issues resulting in downtime errors, lag in execution, and other negative effects.
Trading capital
Market making requires impressive trading capital. Taking this into account, traditional markets often provide MM with credit lines. However, in crypto, this is not a common practice. MMs have to accumulate trading capital on their own and take 100% risk on this investment.
What Yellow Network offers to Crypto Market Makers
- Automation: The bot can run on decentralized or centralized exchanges with customizable strategies
- Consistent spread: Spread can be optimized to maintain an efficient market while ensuring profits for market makers.
- Liquidity: Liquidity can be arranged through hotlink to major exchanges such as Binance, Huobi, Bitfinex, or others through configurable API endpoints. Order books can also be combined with 3rd party liquidity providers.
- Trading strategy: Easy deployment of common trading strategies and option to configure new strategies on the fly through modular and customizable algorithms and scripts.
- Online analytics and monitoring tools to control performance.
Final word
Market makers are the backbone of any asset trading. They create and develop markets for new assets and give new trading venues chances to survive and grow. Both in crypto and traditional markets, MMs provide liquidity and procure the stability of asset prices, which requires a ninja-level of skills and relevant resources. While market making is not for everyone, it’s easier to engage in this activity in the crypto market.
Master the profession, accumulate the required resources and start orchestrating the concert. It’s hard, but it’s worth it.
Written by Julie Plavnik for Yellow Network.
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