Beginner's Guide to Crypto Market Makers

Without deep liquidity and high volume, crypto markets wouldn't have grown as big as they did. What role do crypto market makers play and can we do without them? The short answer is, probably not. As for the longer answer, read this guide from the ChangeHero team.

Key Takeaways

• Market makers are dedicated market participants who maintain an equal amount of buy and sell orders and fill them both simultaneously. Crypto market makers are generally doing the same for digital asset markets.
• The role of market makers is to provide liquidity to their respective markets. More liquidity creates a more efficient market, and this is why crypto trading platforms are willing to compensate them for market making services.
• An advanced crypto market maker engages in both traditional trading strategies and crypto-native modes of trading, such as decentralized finance (DeFi). For example, instead of maintaining a two-way market with buy and sell orders, users can provide liquidity to a pool on a decentralized exchange, which does price matching algorithmically but still rewards users for contributing.

What is Market Making?

Whether it is a physical place or a virtual platform, the idea of a market is usually easy to understand: it is an environment in which people buy or sell goods, assets etc. At the same time, markets are rather sophisticated and need more than simple give and take. For one, as a buyer, you would want sellers to have the goods and services you need and ask for a reasonable price. As a seller, you would want to find a buyer who can accept a price you agree with as soon as you can. To ensure this mutual understanding, traditional finance developed market making.

Definition of Market Making

By definition, the role of a market maker is to provide liquidity to a market or asset by buying and selling it on a trading platform. Liquidity, in turn, is a quality that determines how easily an asset can be bought or sold.

Market makers set ask and bid prices for trading pairs, ensuring a high level of trading activity and attractive environments for it. They achieve this by maintaining buy and sell orders in the same asset, filling the opposite trade as soon as another market participant fills one of their orders.

The goal of market making is not to create liquidity itself: these market participants are in the game for profit. Rather, liquidity is the side effect of market makers competing to fill orders and profit from the bid-ask spread. Nevertheless, everyone wins from increasing market depth, that is, having more activity in the market.

The Role of Market Makers

A market maker in traditional financial markets acts as a liquidity provider to assets such as stocks, bonds, and commodities. Some stock exchanges have so-called designated market makers: singular entities with a monopoly on the order flow. All in all, traditionally, market makers set the pace for the rest of the market participants.

Individual traders can only do so much to create depth in a market. Having a market creator trade a certain amount of the asset on both sides of the market provides the benefit of efficient trading.

Market maker services benefit from price stabilization, reducing volatility and mitigating arbitrage opportunities even between different exchanges. While some traders might want to have more of those, in general, keeping market prices fair and reflective of market conditions benefits a larger share of market participants. A liquid market is also less prone to significant slippage, although, after a certain point, it can become somewhat volatile.

Market Making in Crypto

A major hurdle in the cryptocurrency market and digital assets has been its relative illiquidity. Without a committed entity like a market maker, there could be a market in a cryptocurrency but one with very low liquidity. If digital assets want to be considered as serious financial instruments, market makers are a vital component! They help facilitate token adoption and growth by providing liquidity and enabling traders to buy and sell digital assets.

Market Making in a Decentralized World

Crypto market makers on centralized exchanges (CEX) are largely occupied with the same activities as their traditional counterparts but also face unique challenges, including high volatility and limited regulatory oversight. Despite these differences, crypto market makers employ similar strategies to traditional market makers, including algorithmic trading and risk management.

However, this is only a facet of crypto trading, one that takes after the traditional markets. Another facet that tackles liquidity and order matching differently is decentralized exchanges (DEX). These platforms can’t rely on middlemen and centralized order books so they use more inventive solutions such as automated market makers (AMM). AMM is a market-making algorithmic system that matches orders and determines fees using a formula instead of a bid-ask spread. Liquidity is sourced from a pool maintained by users who are also called liquidity providers and can profit handsomely from the activity.

Incentives and Rewards for Market Making

Market making is not just useful as it is profitable, and the crypto markets are not an exception. An example that shows how incentives are aligned between market makers and other participants is the way they generate income. In traditional finance, they do it by charging a spread on the buying and selling price. In other words, they profit from the difference between bid and ask prices, a wider spread meaning higher profits. However, they must keep a balance between making a profit from this spread and filling as many orders as they can.

Market makers in crypto, much like on stock exchanges, charge a general fee for their service. Although they provide liquidity and keep a market active, they take certain risks holding an asset while trying to sell it. To cover it, cryptocurrency exchanges compensate them with rebates.

Order books on crypto exchanges are largely the same as on a stock exchange: a list of buying and selling prices (bid and ask). In the digital era, most trades are executed automatically at the best price but market makers retain some extra leverage by connecting buyers and sellers at their bid-ask spread if they provide better trade execution than the market at the moment can offer.

Another way for market makers to make money is to capture spreads and arbitrage opportunities. By doing so, they also provide liquidity and reduce price discrepancies between different exchanges. They employ advanced algorithmic trading strategies, continuously monitor market conditions, and adjust their approach to identify and capture these opportunities.

DEXs employ a different approach: since they can’t simply hand out rewards from trading fees, they are built into the algorithms. The reward structures for providing liquidity for an AMM include token rewards and trading fee redistribution. The latter implies that you can receive a share of other users’ trading fees in proportion to the tokens you contributed to the pool. The former is a whole other source of benefit, in the form of protocol tokens which can further turn into voting power or yield farming opportunities.

How Market Making Works in Crypto

Is market making in crypto any different in practice compared to the regular financial market? If we are not talking about AMMs, it follows the same logic: keep an inventory of assets, maintain the bid-ask spread (balanced to bring a profit without disadvantaging customers), and execute and create buy and sell orders.

Setting Up a Market Making Strategy

Despite the basic outline of market making being deceptively simple, there are multiple approaches to it, which can be broadly categorized as active and passive strategies. As the description implies, active strategies involve frequent trades and more involved risk management. Vice versa, passive strategies rely on tighter bid-ask spreads and basic order placement logic to accrue value over the long term with lower risks. Key considerations when choosing between a crypto market making strategy are how involved you can afford to be in the process, what is the profitability horizon vs. risk appetite, and what tools you can employ.

Usual trading activities just won’t do if one wants to be a market pacemaker, so more advanced tools and technologies become a part of a crypto market maker strategy. One, strategic order placement is best achieved with extensive knowledge and analytical tools. Two, algorithmic trading helps to outpace even the automatic order fills. Three, trading bots snipe the arbitrage opportunities before the prices shake out naturally. For the crypto market making bot and software to work, the regular trading interface is too unwieldy, so they are powered by the platforms’ API to skip right to the order execution.

Managing Risk and Inventory

Market makers manage their inventory of digital assets to maintain profitability. The inherent volatility of crypto markets creates a unique challenge, and to handle the risk, they employ risk management strategies such as hedging and diversification.

While inventory management through diversification means acquiring a varied asset portfolio to capitalize on price volatility in different markets or reduce losses, hedging is usually done in the same market with an opposite position. In our guide on investing $100 in BTC in 2023, we have shown how a diverse crypto portfolio performed better than Bitcoin — read it if you are curious.

If diversification can work both ways, hedging is mostly used to mitigate potential losses. How does hedging work? It usually involves derivative assets, such as option contracts. If you go long on a crypto asset but would like to insure yourself against losses if the price goes down, you can get a put option, limiting your potential loss to the premium.

Benefits of Market Making in Crypto

Obviously enough, market-making does not happen in a vacuum. Participants have to be aware of the market dynamics and interact with exchanges and other market participants to provide liquidity and optimize trading conditions.

Liquidity providers contribute to the stability of the cryptocurrency markets by ensuring price continuity and a relatively narrow bid-ask spread. Market makers enable assets with traditionally low liquidity to be traded more frequently, increasing their market visibility and attractiveness to investors.

For Exchanges

Efficient market makers work with exchanges to provide market data and help maintain market liquidity for a fee for their services. Platforms for trading crypto receive massive benefits from the activity of market makers in the form of increased liquidity, tighter spreads, higher trading volume. A portion of their profit share back is nothing compared to the service that does so much for attracting traders.

For Traders

Outside of the market's bounds, market makers collaborate with other participants to share knowledge and best practices when they’re not actively engaged in trading. But when they are, traders see better prices, both for selling and buying, faster order execution and reduced slippage.

If you are not familiar, (price) slippage is the discrepancy between the desired price and the price at which the order executes. It is a particularly important topic in DEX trading because AMMs determine slippage algorithmically, and although users can set slippage tolerance on most popular platforms, it still can become an unpleasant surprise, especially if the liquidity is on the lower side.

For Projects

Liquidity and price continuity are good things for the markets but having a usable market can do wonders for emerging projects too. Crypto projects and token issuers get improved token liquidity, increased market visibility from market making, attracting more investors as a result.

Risks of Market Making in Crypto

That being said, for all the benefits and the profit cryptocurrency market making brings, this activity does come with its own pitfalls and risks. The possible downsides and challenges pose a sizable obstacle that reduces the pool of potential market makers to a handful of savvy traders and professional entities.

Volatility and Flash Crashes

Like we’ve said, crypto’s inherent volatility is something that separates it from market making in traditional financial markets. Arguably, market manipulation is also something present and not simply addressed. Sudden price drops (also called flash crashes) can change the market situation in an instant, rendering any carefully arranged setup useless. Sometimes, they become impermanent loss, meaning if the price of the asset recovers, the trader’s positions return to intended targets. However, more often than not, a sharp drop causes liquidation, which can wipe out a position with collateral, if it was not properly managed.

Regulatory Uncertainty

The crypto industry also does not enjoy the same protections regular trading outlets have. Some may consider less oversight better but in practice it gives way to practices like the aforementioned market manipulation and wash trading that undo the work of market makers.

Legal compliance is also more finicky when it comes to crypto assets. At the same time, it is far from meaning less regulatory scrutiny, sometimes the opposite. The changing regulations that try to catch up with crypto can do it faster than the community and traders can realize.

Technical Issues

Finally, trading crypto poses unique tech-related challenges as well, and we are not only talking about custody and key security. The infrastructure of crypto-focused platforms is generally not as battle-tested as for more long-standing exchanges. Exchange outages, API errors and connectivity problems occur more often than you might expect. And if you try to engage in an activity as intense as market making, a single hiccup can cause far more damage than anticipated.

Evaluating Market Makers

Analysis of what makes a crypto market maker successful and effective should cover a few things: reputation and compliance, service quality, and cost-effectiveness.

Even in crypto, market makers should comply with relevant regulatory requirements and maintain a strong reputation. They should be transparent about their business practices and regulatory compliance, adhere to fair business practices, and avoid conflicts of interest.

Market makers should provide high-quality services and adhere to strong business ethics. Usually, it translates to prioritizing the needs of their clients and maintaining a strong reputation. It also helps if they are transparent about their services and fees.

And speaking of fees, ideally, they should have cost-effective services and competitive pricing. Undercharging will leave a market maker eventually unable to render their services. Overcharging is a cost imposed on the trading platforms, which they can and will eliminate if it is not worth the value.

Conclusion

In a nutshell, what does market making in a crypto market imply? Keep those buy and sell orders open, tighten the spread, and raise the temp across a market of your choice. Crypto markets specifically create exciting conditions for market making, with far more opportunities to take advantage of, but risks of equal magnitude — good work but not one for the faint of heart! Which is why sometimes it is better to let someone more competent do it, even for a small price.

More guides and updates from ChangeHero are posted on our blog, so definitely check them out! To get market insights and crypto news as they happen, follow us on social media: X, Facebook, and Telegram.