Despite regulatory loopholes allowing gray areas in cryptocurrency market-making, market makers will continue to play a crucial role in the market. This article, authored by Min Jung and titled “Market Making: Predatory or Essential?”, has been compiled, translated, and written by TechFlows.
Table of Contents:
What is a Market Maker?
Profit and Risk of Market Makers
Providing Liquidity
Reducing Volatility
Cryptocurrency Projects ↔ Market Makers
Project → Market Makers
Market Makers → Project
Conclusion
Market makers make significant contributions to the market by providing ample liquidity, ensuring efficient trade execution, enhancing investor confidence, and facilitating smoother market operations, thereby reducing volatility and trading costs.
Market makers utilize various structures to provide liquidity, with the most common being token lending protocols and reserve models. In token lending protocols, market makers borrow tokens from project teams to ensure market liquidity within a specific timeframe (usually 1-2 years) and receive call options as compensation. On the other hand, reserve models involve market makers being compensated for maintaining liquidity over the long term, usually through monthly fees.
Just like in traditional markets, clear rules and regulations regarding market maker activities are crucial for the proper functioning of the cryptocurrency market. The cryptocurrency market is still in its early stages and requires reasonable regulations to prevent illegal activities and ensure fair competition. These regulations will greatly contribute to promoting market liquidity and protecting investors.
Which market do you want to trade in? Source: Presto Research
Recent events in the cryptocurrency market have sparked a strong interest in market makers and the concept of market making. However, market makers are often misunderstood and seen as opportunities for price manipulation, including the infamous pump and dump schemes, and accurate information about the true role of market makers in the financial market is scarce. Emerging projects often overlook the significance of market makers and frequently question their necessity. In this context, this article aims to explain what market makers are, their role and importance, and their functions in the cryptocurrency market.
Market makers play a critical role in maintaining continuous market liquidity. They typically achieve this by providing simultaneous buy and sell quotes. By buying from sellers and selling to buyers, they create an environment for market participants to trade at any time.
This can be likened to the role of a used car dealer in our daily lives. Just as these dealers allow us to sell our current vehicles and purchase used cars at any time, market makers play a similar role in the financial market. Global market maker Citadel provides the following definition of market makers:
Figure 2: Role of market makers defined in traditional financial markets. Source: Presto Research
Market makers are also crucial in traditional financial markets. In the NASDAQ, for example, there are an average of about 14 market makers per stock, totaling around 260 market makers. Additionally, in markets with lower liquidity, such as bonds, commodities, and foreign exchange, most trades are conducted through market makers.
Market makers profit from the bid-ask spread of financial instruments. As the selling price is higher than the buying price, market makers profit by purchasing financial instruments at a lower price and selling the same financial instruments at a higher price (i.e., the bid-ask spread).
Figure 3: Bid-ask spread
– Consider a scenario where a market maker offers a buying price of $27,499 and a selling price of $27,501 for an asset. If these orders are executed, the market maker buys the asset at $27,499 and sells it at $27,501, earning a profit of $2 ($27,501 – $27,499). This profit represents the bid-ask spread.
– This concept is consistent with the example of a used car dealer mentioned earlier, where the dealer purchases a used car and then sells it at a slightly higher price, profiting from the difference between the buying and selling prices.
However, it is worth noting that not all market-making activities can generate profits, and market makers may indeed incur losses. In rapidly fluctuating markets, the price of a particular asset may sharply fluctuate in one direction, resulting in the execution of only the buying or selling price instead of both simultaneously. Market makers also face inventory risk, which is the risk associated with holding assets that cannot be sold. This risk exists because market makers always hold a portion of their market-making assets to provide liquidity.
For example, in a scenario where a used car dealer buys a car but cannot find a buyer, coupled with an economic recession leading to a decline in used car prices, the dealer will suffer financial losses.
Why Do We Need Market Making?
The primary goal of market making is to ensure sufficient market liquidity. Liquidity refers to the ease and speed at which assets can be converted into cash without causing financial losses. High market liquidity reduces the impact of transaction costs on any specific trade, minimizes losses, and enables the efficient execution of large orders without significant price fluctuations. Essentially, market makers facilitate investors in buying and selling tokens faster, in larger quantities, and with ease at any given time without causing significant disruptions.
Figure 4: Why liquidity matters. Source: Presto Research
For example, suppose an investor needs to purchase 40 tokens immediately. In a market with high liquidity (Order Book A), they can buy 40 tokens immediately at a price of $100 each. However, in a market with lower liquidity (Order Book B), they have two options: 1) buy 10 tokens at $101.2, buy 5 tokens at $102.6, buy 10 tokens at $103.1, and buy 15 tokens at $105.2, resulting in an average price of $103.35, or 2) wait for a longer period for the tokens to reach the desired price.
As demonstrated in the previous example, the ample liquidity provided by market makers helps mitigate price volatility. In the scenario mentioned above, after the investor purchases 40 tokens, the next available price in Order Book B is $105.2. This indicates a price fluctuation of approximately 5% in a single trade. In the real-world cryptocurrency market, even small trades can cause significant price changes for assets with low liquidity. This is especially true during market fluctuations when fewer participants can result in significant price volatility. Therefore, market makers play a crucial role in reducing price volatility by bridging this supply-demand gap.
Figure 5: How market makers help reduce volatility. Source: Presto Research
The aforementioned role of market makers ultimately enhances investor confidence in projects. Every investor wants to be able to buy and sell their assets with minimal transaction costs when needed. However, if investors perceive a significant bid-ask spread or require a considerable amount of time to execute the desired trade quantity, they may become discouraged even if they have a positive view of the project. Therefore, if market makers remain active in the market, providing liquidity, it not only lowers the entry barriers for investors but also incentivizes them to invest. This action, in turn, brings in more liquidity, creating a virtuous cycle and facilitating an environment where investors can trade with confidence.
While there are various contractual structures between market makers and projects in the cryptocurrency market, including token lending + upfront payment contractual structures, the most widely used contractual structure (token borrowing + call options) works as follows:
Figure 6: Project ↔ Market Maker structure. Source: Presto Research
– Market makers borrow the necessary tokens for market-making activities from projects. During the initial listing phase of tokens, there is often a limited supply of tokens available in the market. To offset this imbalance, market makers borrow tokens from projects, usually with an average term of 1-2 years (equivalent to the term of the market-making contract) to ensure market liquidity.
– As compensation for their market-making services, market makers receive the right to exercise call options to purchase tokens at a predetermined price when the loan expires. Since projects have limited cash resources and do not rely on fiat currencies, call options are provided as compensation. Additionally, the value of call options is directly related to the price of tokens, providing market makers with protection against early pump and dump schemes.
– Market makers, during the term of borrowing tokens, negotiate with project teams to provide services to ensure maximum bid-ask spread and sufficient liquidity. This arrangement benefits trading in a favorable liquidity environment.
In summary, market makers borrow tokens from projects, receive call options, and provide services with the aim of ensuring liquidity within a specific bid-ask spread during the borrowing period. However, it is important to note that legitimate market makers do not make any commitments regarding prices.
Limited Regulation of Market Makers in the Cryptocurrency Market
Negative perceptions of market makers in the cryptocurrency market are primarily due to the lack of regulation compared to traditional financial markets. In traditional stock markets such as NASDAQ and the New York Stock Exchange, market makers are required to maintain a minimum buying and selling price of at least 100 shares, and if corresponding orders are placed, they are obligated to fulfill those orders (see Figure 7). There are also very specific requirements for market makers, such as only placing orders within a certain range (e.g., within 8% or 30% for large-cap stocks). These measures prevent market makers from placing orders at absurd prices (far from the highest buying price/lowest selling price) and only placing corresponding orders when there are profit opportunities.
Figure 7: Rules on market making in the New York Stock Exchange. Source: Presto Research
However, as mentioned earlier, market making in the cryptocurrency market still lacks regulation compared to traditional financial markets. Unlike in traditional financial markets, there are no separate licenses or regulatory bodies overseeing these operations.
Therefore, news reports often highlight companies illegally profiting under the guise of “market making.” The biggest issue is that while traditional exchanges like NASDAQ impose strict penalties and regulations on fraudulent market-making practices, decentralized cryptocurrency markets lack substantial penalties for deceptive market-making practices. This clearly exposes the glaring regulatory oversight and underscores the need for regulation in the cryptocurrency market at the same level as traditional financial markets.
Despite the regulatory loopholes allowing gray areas in cryptocurrency market-making, market makers will continue to play a crucial role in the market. Their function of buying financial instruments from sellers and selling them to buyers to provide liquidity remains fundamental. Especially in cryptocurrency markets with insufficient liquidity, market makers help reduce trading costs and volatility, creating an environment where investors can trade with more confidence. Therefore, by incorporating market makers into the system and promoting fair competition and sound market-making practices, we can expect an environment where investors can trade with greater security.