Alex Fatuliaj
September 20, 2023
Crypto Discussions

What even are market makers?


A market maker (referred to as MM) is an entity that creates the trading environment for a particular asset by offering the prices at which traders engage with the asset and managing the liquidity.

Decentralised exchanges (DEX) have automated market makers – they use maths and algorithms to balance liquidity in the asset pools via token price. More details on how the genesis AMMs worked can be found in our first post on decentralised market makers here: https://thoughts.simplicitygroup.xyz/p/amms-101

A centralised exchange (CEX) MM on the other hand is a relatively manual position. Or, rather, a relatively centralised position. Their main function is to provide liquidity, not just balance it.

With this comes another key difference: they themselves hold the token inventory and continuously trade the token. They quote the price at which they will buy an asset (bid price) and the price at which they will sell an asset (offer price), which allows investors to then buy assets at the offer price and sell them at the bid price, where the MM is the one completing the trades.

How do market makers work in crypto?


Market makers work in the same way as in traditional finance at their core – they create the trading environment. In crypto however, they also facilitate other asset transacting activities such as Over the Counter trades (i.e. trades that are off the trading venue), and algorithmic execution services where they will seek to buy/sell following TWAP or VWAP strategies, diluting the impact of large orders in the market.

With trading environments in mind, there are typically three situations in crypto market making with respect to liquidity management:

  1. The CEX uses its own liquidity to make markets for project tokens. This requires projects depositing their tokens to an exchange for liquidity. A retainer fee is involved.

  2. The CEX invites MMs to use their liquidity to make markets for tokens listed on the CEX. This can require MMs to deposit their tokens to an exchange for liquidity. For more liquid assets, the CEX may provide the MM with the required liquidity on loan. A retainer fee is involved.

  3. The projects will find an external MM to trade the tokens on the CEX via the project’s own account using API keys. This means the MM can only trade - not withdraw or deposit funds. A retainer fee is involved.

  4. The projects find an external MM that they loan a portion of their token supply to for the MM to make markets with. Often this comes with a call option, meaning that the MM can buy the token at a predetermined price (strike price) from the project instead of returning the loan - the idea being that it’s in the MM’s interest to increase the token price through market making to then buy it back at a lower strike price to make a profit. There is usually no retainer fee.

Let’s dive in.

Temptation Island Jump GIF by USA Network

How do market makers make money?


Retainer

Projects or CEXs pay market makers a monthly fee to make markets.

Spread

The main way market makers profit is from the difference between their bid and offer prices (sometimes called “ask” price, as in the image below) - this is known as spread. The bid price is below the offer price, so MMs buy an asset at the bid price from any people selling, and then sell it again to at the offer price to any people buying, taking the difference as profit.

As the number of buyers increase, the MM increases the offer prices to maximise revenue, however, it also has to increase the bid price to ensure the spread is thin enough to stay competitive (and vice versa for downwards movements).

This is because in a liquid market there will be many MMs competing to quote the best bid/offer (where ‘best’ refers to how tight the gap is between the bid/offer prices to the mid-price (i.e. the actual price of the asset is somewhere in-between the bid and offer prices)). Therefore, if a MM wants their orders to be filled they will need to quote bid/offer prices close to the mid-price and as a result the spread will be tighter.

In an illiquid market on the other hand there will be few MMs, allowing the MMs who are participating to quote bid/offer prices further away from the mid-price as investors in this market who want to sell/buy (respectively to the bid/offer prices they’ll get) will have to settle for a higher bid-offer spread due to a lack of choice.

"It could be that the projects don't want the MM to quote too tight, as that can result in loss during times of high volatility. Most MM handling token loans for smaller projects won’t be incentivized to quote very tight as they are putting their own capital at risk. Sometimes if the market is organically liquid, it is not in the interest of the MM (or the project) to compete for the best [bid/offer price] because, [whilst] you will capture volume, you are more likely to get hit and end up being directional." - Nico

It is also important to note that more illiquid markets, pertinent to most altcoins, and in particular during the bear market, tend to have volumes that are too low to result in a profitable market making operation from the bid-offer spread (offer price – bid price). This opens up a need for other incentive structures for MMs, because otherwise they will often take matters into their own hands to stay afloat.

This leads to the unofficial ways that market makers earn, which are seldom spoke about.

What about the unofficial ways market makers make money?


Directionality

A market maker owning your liquidity can be a problem if they’re directional, meaning they trade with the trend: as well as filling orders, they also place longs or shorts given their insider information.

This means the token price will move in one direction more than it should if it had only real demand and supply from the community, which is partially responsible for movements of 100’s x and then collapses of 99%.

"The best question you can ask a market maker if they are good is, 'What is your maximum drawdown from your peak?' That will tell you if they ever took a directional bet and how much they lost." Adeel - Propeller Heads; Simplicity Group

Although bad, this is the lesser of the three evils.

Retainer Model

Another popular business model for MMs is that of a retainer-based model: projects pay market makers a retainer based on KPIs around things like uptime and depth, meaning the market maker earns from providing a service of managing projects’ liquidity using the project's own tokens without the loan structure in place.

However, this often incentivises market makers to focus on sales and amassing large numbers of clients, resulting in a bit of a catch-22 - managing a project’s liquidity properly and trading well on a project’s behalf requires significant man hours, which does not align as a priority within the business model of these MMs.

For many MMs, a poor quality of service devolves into a situation where they need to offer ethically dubious products and services to stay competitive, often involving washed* volumes.

*This means that they use bots to buy and sell your asset between their own accounts to create the illusion of volume, when in reality the organic trading volume is a fraction of what it seems.

Some projects may want this to seem more popular to attract organic volumes, especially during the bear market, but it comes at an expense to their community and investors who may be misled into investing into a market that they otherwise would not have touched.

Example of a token with high, fake volumes and low real liquidity(token name abstracted to prevent defamation)


Shorts

If you don’t know about shorts, it’s when you (technically) borrow an asset you think will go down in price to sell it, to then buy it back later at a lower price and return it to the person you borrowed it from, leaving you a nifty profit.

If the market doesn’t have much volume (i.e. the project's community isn’t big + we’re in a bear market), and the MM “borrowed” your tokens to “market make” with them, can you guess what they’re very likely going to do?

In the case of most altcoins their markets are usually far easier to demoralise (bring down) than rally (bring up). This leads to a scenario where it is far more profitable for a MM to short an asset than to trade above a given strike price for that loan, especially during periods of low volumes and altcoin interest. In these times, any ‘strike price’ provided by a loan MM is nothing more than a smoke and mirrors to make projects believe that the MM’s incentives (bringing the token price up) align with their own.

Arguably, this is a huge cause of why the altcoin market crumbles so severely in comparison to Bitcoin and Ether.

"No projects trading below a 9-figure market cap should even consider the loan option." - Fabian - Trireme


Nonetheless, below are three examples of tokens that used the “borrow” model MMs (arguably cherry picked, but more so to highlight the reality of what happens to most low-volume, loan model projects):


So, do market makers kill projects?


The answer is sometimes. Market makers kill projects, sometimes. Not all market makers. Not all the time. But sometimes. And sometimes turns to oftentimes when you’re talking about a low-popularity altcoin in the bear market. Some short, some wash trade, some don’t provide good enough liquidity, and so on.

If you thought VCs dumping was a problem, well… a bigger and faster problem is your choice of MM.

Now, we understand that a lot of projects that launch aren’t good; their tokenomics are bad, they have no real product, they’re not solving a real problem, etc. All of this to say that they likely wont succeed in the long term, and are in essence a slow rug.

However, MMs that prey on these projects and profit by killing their tokens do so at the cost of the community and brand image of the space. It’s hard to enter crypto as an individual or institution if all you hear are how your friends were rugged, and all you see are the charts like the ones above.

Hence, we are writing this article to shine a light on how these things happen, and help founders take a better path.


So, what market maker do I use?


Realistically, if you’re a new project, you should be only launching on DEXs until your volumes reach at the very least 8 figures, especially in the bear market.

A lot of projects want to go on a CEX regardless - for the hype. That’s fine, as long as you conduct a good cost-benefit analysis. However, make sure you chose a MM that works for you. Do not go for the token loan model to save money, because it will likely not end well.

Are there affordable market making business models that truly align a project’s own priorities with that of the MM?

There are some trading shops that achieve this alignment in a roundabout manner. As an example, Trireme Trading operates primarily as an asset manager for project treasuries, whilst also providing MM services and supporting their markets as part of the same fee (this is not a sponsored post).

Their profitability lies in effectively trading markets and growing treasuries, and thus is not dependant on the token’s direction, volumes, or price. They are incentivised to properly manage and trade a project’s markets because that grows the projects’ treasury, which yields the return for them.

How are crypto market makers different from traditional market makers?


In crypto, a lot of market makers are directional and work for themselves. Even most of the ones that charge a fee instead of simply “borrowing” the tokens (i.e. options 1 and 2, in our list of 4 above) still own your liquidity since they aren't non-custodial - the funds are sent to their own wallets, allowing them to trade for a P&L split with little transparency as they please. It is important to note that some newer MMs, such as Trireme and Kaizen, operate on a non-custodial retainer (and thus completely transparent) basis to alleviate these worries.

In traditional markets, MMs work for the exchanges, not the company behind the asset – this means that there is less counter-party risk of the MM trading for their own benefit, as they are inherently aligned with creating the most fair and liquid market for the exchange, instead of trading an asset for profit like a prop trading desk.

Therefore, as a project, it is crucial that you do your due diligence on what market maker you use.

Conclusion


All in all, this is how market makers operate and what to be cautious about. It is incredibly important to understand everything about the industry as a founder, especially everything about something as important as market makers.

If you need help, do not hesitate to reach out to Simplicity Group.


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