Despite regulatory loopholes allowing for gray areas in cryptocurrency market making, market makers will continue to play a crucial role in the market. This article, originally written by Min Jung in the article “Market Making: Predatory or Essential?” and compiled, translated, and written by TechFlows, explores the concept of market making and its importance.
Table of Contents:
What is a Market Maker?
Profit and Risk of Market Makers
Providing Liquidity
Reducing Volatility
Cryptocurrency Projects ↔ Market Makers
Project → Market Maker
Market Maker → Project
Conclusion
Market makers contribute significantly to reducing volatility and transaction costs by providing liquidity, ensuring efficient trade execution, enhancing investor confidence, and facilitating smooth market operations.
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 projects to ensure market liquidity within a specific time frame (usually 1-2 years) and receive call options as compensation. On the other hand, the reserve model involves market makers receiving compensation for maintaining liquidity over a long period, usually through monthly fees.
Just like in traditional markets, clear rules and regulations governing market making 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 help promote market liquidity and protect investors.
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 infamous pump and dump schemes, and there is a lack of accurate information about the true role of market makers in the financial market. 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 crucial 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 compared to the role of a used car dealer in our daily lives. Just as these dealers allow us to sell our current car and buy a used car at any time, market makers play a similar role in the financial market. Citadel, a global market maker, provides the following definition of market makers:
“In financial markets, a market maker is a company or an individual that stands ready to buy and sell a particular asset in order to facilitate the trading of that asset. Market makers provide liquidity to the markets. They are always willing to quote both sides of a trade.”
Market makers are also crucial in traditional financial markets. In Nasdaq, for example, there are an average of about 14 market makers per stock, totaling about 260 market makers. Additionally, in less liquid markets such as bonds, commodities, and forex, 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 buying the financial instrument at a lower price and selling the same financial instrument at a higher price (i.e., the bid-ask spread).
Consider the following scenario: a market maker simultaneously 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 for $27,499 and sells it for $27,501, earning a profit of $2 ($27,501 – $27,499). This profit represents the bid-ask spread.
However, it is worth noting that not all market-making activities can generate profits, and market makers may indeed incur losses. In fast-moving markets, the price of a specific asset may sharply fluctuate in one direction, resulting in only the buying or selling price being executed, rather than 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.
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 allows for efficient execution of large orders without causing significant price fluctuations. Essentially, market makers facilitate faster, larger, and easier buying and selling of tokens for investors at any given time without causing major disruptions.
For example, imagine an investor who needs to buy 40 tokens immediately. In a market with high liquidity (Order Book A), they can buy 40 tokens at a price of $100 per token immediately. 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, with an average price of $103.35, or 2) wait for a longer period for the tokens to reach the desired price.
As the above example demonstrates, the abundant liquidity provided by market makers helps mitigate price volatility. In the scenario mentioned earlier, after the investor buys 40 tokens, the next available price in Order Book B is $105.2. This indicates a price fluctuation of approximately 5% caused by a single trade. In the real world of the cryptocurrency market, even small trades can cause significant price changes for assets with low liquidity. This is especially true during market volatility, where fewer participants can lead to significant price fluctuations. Therefore, market makers play a crucial role in reducing price volatility by bridging the supply-demand gap.
The role of market makers mentioned above ultimately enhances investor confidence in the project. Every investor wants to be able to buy and sell their assets at the lowest transaction cost as needed. However, if investors perceive a large 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, by remaining active in the market and providing liquidity, market makers not only lower the entry barriers for investors but also incentivize them to invest. This in turn brings more liquidity, forming a virtuous cycle and creating an environment where investors can trade with confidence.
Although there are various contractual structures between market makers and projects in the cryptocurrency market, including token lending + upfront payment contract structures, the most widely used contractual structure (token borrowing + call options) works as follows:
Market makers borrow the tokens they need for market-making processes from the project. In the initial stages of token listing, when there is often a shortage of available tokens in the market, market makers borrow tokens from the project, 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 are granted the right to exercise call options at the expiration of the loan. The call option gives them the right to purchase tokens at a predetermined price. Since projects have limited cash resources and do not rely on fiat currency, they provide call options as compensation. Additionally, the value of the call option is directly related to the price of the token, providing market makers with protection against early pump and dump schemes.
During the loan period, market makers engage with the project to provide services and ensure maximum spread and sufficient liquidity. This arrangement is beneficial for 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 spread during the borrowing period. However, it is important to note that legitimate market makers do not make any price commitments.
Insufficient Regulation of Market Makers in the Cryptocurrency Market
The negative perception of market makers in the cryptocurrency market is primarily due to their lack of regulation compared to traditional financial markets. In U.S. stock markets such as Nasdaq and the New York Stock Exchange, for example, market makers are required to maintain a minimum bid and ask size of 100 shares and have an obligation to fulfill orders if corresponding orders are received (see Figure 7). Market makers also have very specific requirements, such as being able to place orders within certain ranges (e.g., 8% or 30% for large-cap stocks). These measures prevent market makers from placing absurd orders (far from the highest bid/lowest ask) and only placing corresponding orders when there is a profit opportunity.
However, as mentioned earlier, market making in the cryptocurrency market still lacks sufficient regulation compared to traditional financial markets. Unlike traditional exchanges like Nasdaq, there are no separate licenses or regulatory bodies overseeing these operations in the decentralized cryptocurrency market.
As a result, news reports about companies illegally profiting under the guise of “market making” are frequently seen. The biggest issue is that while traditional exchanges like Nasdaq impose strict penalties and regulations on fraudulent market-making activities, the decentralized cryptocurrency market lacks substantial penalties for deceptive market-making practices. This clearly exposes the evident regulatory oversight and highlights the need for regulatory requirements in the cryptocurrency market on par with traditional financial markets.
Despite regulatory loopholes allowing for 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 low liquidity, market makers help reduce transaction 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 assurance.
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