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Intro

Market makers play a crucial role in ensuring continuous liquidity within financial markets by simultaneously offering buy and sell quotations. By purchasing from sellers and selling to buyers, market makers create an environment that allows market participants to conduct transactions conveniently.

Market Makers and Traditional Finance

Market makers can be compared to used car dealerships, which facilitate the buying and selling of vehicles. Similarly, in financial markets, market makers provide the necessary liquidity for transactions. According to Citadel, a global market maker, these entities are essential for market efficiency.

On the NASDAQ, each stock typically has around 15 market makers, with approximately 250+ market makers operating in total. In less liquid markets, such as those for bonds, commodities, and foreign exchange, the majority of trades rely on market makers.

Profits and Risks of Market Makers

Market makers generate revenue from the bid-ask spread, the difference between the bid price and the ask price of a financial instrument. The ask price is higher than the bid price, allowing market makers to profit by buying at the lower bid price and selling at the higher ask price.

For example, if a market maker sets a bid price of $37,699 and an ask price of $37,701 for an asset, executing these orders results in a profit of $2. This profit represents the bid-ask spread, analogous to a used car dealer who buys a car and sells it at a higher price to earn a profit.

However, market making is not without risks. In volatile markets, sharp price movements can result in only one side of the bid-ask spread being executed, leading to potential losses. Additionally, market makers face inventory risk, which arises from the necessity of holding assets to provide liquidity. This risk is similar to a used car dealer who cannot sell a vehicle and faces a downturn in car prices, resulting in financial loss.

Ensuring Substantial Liquidity

The primary objective of market making is to ensure ample liquidity in the market. Liquidity refers to the ease with which an asset can be converted into cash without incurring significant financial loss. High market liquidity reduces transaction costs, minimizes losses, and enables the efficient execution of large orders without causing significant price fluctuations. Market makers facilitate investors' ability to buy or sell tokens quickly, in larger volumes, and with greater ease, thereby preventing substantial market disruptions.

Consider an investor who needs to purchase 50 tokens immediately. In a highly liquid market (Order Book A), the investor can buy 50 tokens at $100 each. However, in a less liquid market (Order Book B), the investor faces two options: purchasing 20 tokens at $101, 5 tokens at $102, 10 tokens at $103, and 15 tokens at $105, resulting in an average price of $102.40, or waiting for the tokens to reach the desired price. This example illustrates the critical role market makers play in ensuring liquidity and preventing substantial price disparities.

Reducing Volatility

In real-world cryptocurrency markets, even small trades can trigger significant price changes for highly illiquid assets, particularly during periods of market volatility. Market makers reduce price volatility by bridging the supply-demand gap, thus stabilizing the market.

Market making ultimately fosters increased investor confidence. Investors desire the ability to buy and sell their holdings with minimal transaction costs. If the bid-ask spread is wide or if executing the desired quantity of transactions takes considerable time, investors may be discouraged, regardless of their positive view of the project. Active market makers consistently providing liquidity lower entry barriers for investors, stimulating further investment and creating a virtuous cycle of increased liquidity and investor confidence.

Crypto Projects and Market Makers

Various contract structures exist between market makers and projects in the crypto market. One widely used structure is the token loan plus call option arrangement. In this structure, the project lends tokens to the market maker for market-making purposes. During the early stages of a token listing, demand often exceeds supply due to the limited number of available tokens. To counteract this imbalance, the market maker borrows tokens from the project, typically for a term of 1–2 years, ensuring market liquidity.

In return for their services, market makers receive a call option on the borrowed tokens at the loan's maturity. This call option allows them to purchase the tokens at a predetermined price, compensating them without relying on fiat currency. The value of the call option correlates with the token's price, safeguarding market makers against early pump-and-dump schemes.

With the borrowed tokens, market makers negotiate with the project to maintain a maximum spread and sufficient liquidity, facilitating trades within a well-sustained liquidity environment. However, legitimate market makers do not guarantee price levels.