Brilliant idea that cannot be achieved with anything but blockchain. Check. Well designed and well-written whitepaper that hits the investor sweet spot. Check. Team of star crypto advisors. Check. Bunch of crypto funds and family offices eagerly waiting for your presale to start. Check. Crypto exchanges, willing to list your token for a fraction of Binance’s fee. Check. Sounds like you got everything right and your biggest problem is having to properly budget all these ICO millions you are going to raise.
However, as you watch the market on your token, something is not right. There is no trading happening on that great exchange you’ve chosen and whoever started to get FOMO from not investing into your token is now scared away by the 10% bid-ask spread. Even worse, the first time one of your early investors tries to sell part of his position he causes the price to plummet by 50%, helped by a bunch of stop loss orders placed by the few day traders looking at your token. Even though the price slowly bounced back, enough traders got burned by this one incident to make volumes disappear almost completely. You keep updating your Git and Telegram channels, but there is a sense of exodus in the air. Your ICO journey seems to come to a halt and you are unsure on how to jump start the dying engine.
Okay, that might have been a little too dark. But the point I’d like to illustrate is that crypto market liquidity matters and it will continue to matter until your token gets listed on Coinbase for free. Before that happens, you need to think about liquidity and realise that it is as important as your product, team and marketing.
It is common knowledge that most ICOs lack liquidity. What is not common knowledge in the crypto space is that there are time tested tools to create it. This situation is not unique to the crypto markets, but is fundamental to most new or “exotic” assets. The reason you don’t see lack of liquidity in the “traditional” capital markets is because there’s a whole industry which exists to solve this problem. It is called Market Making.
If you are planning an ICO and you don’t have a market making plan, this article is for you.
Who are the market makers
Before we dive into the issue of ICO liquidity and how market makers may solve it, it is important to understand the basics of market making. If you are not a trader, chances are that you only see one side of the market — investors, day-traders, speculators. All of them are called market takers. They take liquidity from the market. Their goal is to make money on their trades afterwards, whether it is in minutes, days or years. Two things are important to market takers:
· Liquidity, or being able to execute the size they want at cheapest price possible.
· Immediacy, meaning being able to execute the trade as quick as possible.
Market takers intentionally take risks associated with their positions. They buy or sell different financial instruments because they are willing to take the associated risk and anticipate profit in future.
Market makers are on the other side of the equation, they are the “invisible hand” of financial markets. Whatever asset you are buying or selling, the odds are you’ll trade against one of them. Market makers provide liquidity and make money by receiving the market spread. The spread is the difference between the bid and ask (or bid-offer) prices on the market, or simply the difference between the buy and sell price, like when you are exchanging money in a currency exchange kiosk. The difference lies in how the exchange kiosks make money. Similarly, spread is how market makers make money.
In liquid markets with many buyers, sellers and market makers, the spreads are small. Market makers need to make a very large number of trades to get profits. They use very advanced quantitative algorithms to take very short term positions — these could be hours, minutes or seconds. The higher the asset volatility (i.e. enough movement in the market) and the higher the trading volumes, the more trades market makers are able to make, and the more profit they make.
However, market making is not risk-free. ICO market makers take on risk at the whim of outside world of market takers. They make profit initially but manage their risks afterwards. If there is an even number of buyers and sellers on a screen, they would have almost no risk by the end of the day, while a FOMO rally with no sellers or a panic sell would typically be a challenging situation for them.
What is a cost to a market taker is the primary source of income to the market maker. As in any many other businesses, market makers face a trade-off between the margins earned and the volumes traded. And as in any other business, if the margins are high, competition comes in. Unfortunately, it can also result in a chicken-and-egg situation where there is no volume because the spread is too wide and the market maker is unwilling to take more risk by tightening the spread until he gets the confirmation that there will be enough volume going through. In these situations, the parties most interested in generating liquidity (asset issuers and exchanges) create incentives for market makers to provide better prices. Exchanges generally create more favourable conditions for market makers by reducing or eliminating trading fees. For asset issuers, paying a monetary stipend for a definite period of time is the most straightforward way to incentivise provision of liquidity.
Now, that was a lot of information so I will summarise it once again in the simple table below.
Why crypto markets lack liquidity, or “ICO liquidity trap”
Top 20 crypto currencies have enough trading volume for market makers to compete against each other for free. Smaller tokens and ICOs, on the other hand, face what I call an “ICO liquidity trap”. This happens because there are not enough market makers working on providing liquidity for them.
ICOs need other players — crypto exchanges and investors — to contribute to their token liquidity. At the same time crypto exchanges and crypto investors want an assurance of a liquid market in order to participate. This creates a vicious cycle. Let’s examine it in more detail.
- ICO issuers face a bottleneck when trying to secure an exchange listing. Top crypto exchanges like Binance could easily charge 7 digit numbers for a listing. Even with the cheaper ones you still have to pay substantial 6 digit amounts.
- Crypto exchanges face significant setup costs to list a new token (due diligence, setting up cold storage etc.) Therefore, they are not thrilled with the prospect of a new listing if they are not sure about its potential liquidity. Exchanges simply don’t want another “ghost town” token on their platform with hardly any trading going on and a bunch of disgruntled investors trying to get rid of whatever tokens they have left.
- Investors (market takers) see lack of liquidity as big showstopper as well. To start with, wide spreads really limit the number of strategies they can adopt. 15% wide spread means they will have to pay 7.5% to initiate the trade and another 7.5% to close it. Secondly, illiquid markets are much easier to disrupt. Even a relatively small seller can wreak havoc, potentially triggering other investors’ stop loss orders resulting in a panic sell. You might think a buyer won’t create a similar problem, but think twice. A sudden rally in an illiquid token could trigger a bunch of FOMO investors to join, resulting in an unsustainable rally and pump-and-dump accusations in the end.
As you can see there is a big chasm between ICO issuers, exchanges and investors. It is summarised in the infographic below.
How can market makers solve the ICO liquidity problem?
As in traditional markets, market makers are needed in crypto markets to solve the ICO liquidity trap by helping guide the “invisible hand” of the market. Getting the services of a professional ICO market maker can fuel the market for your tokens. And once the ICO brings a market maker on board, the magic happens:
- Exchanges become more relaxed about the listing process
Exchanges have one problem less if an ICO comes to them with a Market Maker attached. If they know that professional market makers are engaged to create liquidity for the new token they would be more likely to charge smaller listing fee.
2. New and more sophisticated investors are lured by increased liquidity
The tighter the market for your ICO, the cheaper it is for a new investor to trade in and out of his positions. That in turn can attract a more diverse trading community (including institutional investors) employing very different strategies, which would otherwise not be feasible. Unlike the 15% spread I explained above, tightening the market to 2% spread will attract more sophisticated investors who can do technical analysis, correlation arbitrage versus other tokens. These are the strategies that are not feasible in the 15% spread market.
In addition to that, a liquid market prevents big orders from disrupting it, generating confidence in the token.
So, in the same way as having a market maker helps you to get listed on a crypto exchange, it helps you attract investor interest. This excellent article on market making in crypto also explains why market making should be “a basic service that all cryptoprojects needs to provide to investors before listing on an exchange”.
3. Liquidity breeds liquidity
Once the ecosystem of investors starts growing, an amazing thing happens — there are more orders in the order book, meaning even better liquidity for market takers. Since the number of market takers increases, market makers start increasing the size on their orders (volume is their friend, remember). And as the trading volume goes up, more market makers will show up for free, lured by promising numbers. On the exchange side, an ICO would have more leverage in negotiating a secondary exchange listing when the first listing is liquid.
So, the good news — you don’t need a crypto market making services forever. You often need market maker support until the volumes are good enough for them to maintain the trading ecosystem on their own. That magic number in the crypto markets, by the way, is about $1mln per day.
4. Volumes and investor confidence drive the token price up
Higher volumes would inevitably make an ICO project noticeable, bringing in lovers (and haters). Vast majority of that interest will result in more people considering the token as an investment. Higher demand would drive the price up. Lack of sudden price movements further boosts the investor confidence and demand. High trading volumes would also help the token economics as it is easier to sell your project to a consumer or new business partner when there is significant trading going on in the background.
Here is an infographic to summarise how you can avoid liquidity problem for your ICO by engaging a professional crypto market maker.
In summary, if you are an ICO or a crypto project, do not forget to include a professional market maker in your budget planning!
There are quite a few things you need to get right for an ICO to work. Liquidity is one of them. It enables your token economics and helps exchanges and investors produce the best possible result for your ICO. But crypto liquidity rarely comes by itself. To create a liquid market for your ICO, you need the support from professional market makers who have the tools to jump start the trading of your token. Make sure to think about market making requirements and factor this service in when you are planning your ICO budget.