The basics of Market Making
Market making is not new. The earliest known instance of market making was recorded in 1620 when Christoffel and Jan Raphoen became the intermediary. They buy the shares of Dutch East India company from those who want to sell and sell it to those who want to buy.
Even four decades later the basic concept of market making is same. It is an act of providing two-sided quotes – bid & ask along with the quote size for a crypto on an exchange. This is to facilitate trading, increase liquidity and market depth.
However crypto market markets are highly volatile and there is often limited two-sided flow, making the bid-ask spread difficult to capture. Nowadays market makers use proprietary software to show both bid-ask quotes and these keep on adjusting constantly, based on market price.
Market makers are specialists and the key differentiators are history, experience, technology and software.
Centralised Exchange and Decentralised Exchange
Centralised exchanges are broker platforms that connect buyers and sellers. Crypto on a centralized exchange have a bid price and an ask price. And the difference between the price is the spread. There are two types of orders –
- Makers Order – Maker orders are where the buyer or seller places the order with a defined price limit at which they are willing to buy or sell at. These orders add liquidity to the exchange
- Takers Order – Taker orders are orders that are executed immediately at the best bid or offer. Taker orders are executed at the highest bid order and the lowest ask order.
Decentralised Exchanges use Automated Market Maker or AMM to provide liquidity. Central limit order books are difficult and impractical too therefore they use AMM. AMMs work by allowing liquidity providers to deposit tokens, usually in equal amounts, into a liquidity pool. Some DEX follow even traditional central limit order book model and offer both AMM and CLOB.
Crypto markets pose a lot of challenges for the market makers. These are open 24*7 without geographical boundaries with options to hold crypto in wallets too. Also crypto exchanges are unregulated which can lead to potential price manipulation. The derivatives market is still evolving and it is not as developed as the traditional market.
The future of Market Making
The rise of decentralised exchanges have led to the use of AMM but are they truly capable to compete with the order based book exchanges?
Instead of order based book, market makers use pricing algorithm in DEX for price quote. This is an easy and swift solution and the fees is distributed to the liquidity providers in the pool. This is how they earn their income by pooling reserves to create liquidity. It is an ideal, by the book situation. However, there are some drawbacks to AMM price quotes.
These algorithms don’t take into account various external factors. They do not adjust price quotes on information rather arbitrageurs change the token allocation to correct price quotes and their charges comes from liquidity providers.
The future of market making is bright as crypto markets are becoming more institutional and once the demand grows the need for liquidity providers will also grow. The future of crypto financial markets belongs to advanced market makers using off-chain order books DEXs.
