Market Makers: How They Work and Unknown Unknowns

At Thrilld Labs, we realise how important market makers are for the functioning of the crypto space, as well as for many Web3 projects and individual buyers and sellers. This article provides an overview of the two general types of market makers, how they have evolved, how they operate, and what to look for (or avoid) when engaging with them.

Introduction

Almost every smooth trade, whether in TradFi or crypto, is made possible by a market maker working behind the scenes. How? By absorbing volatility, providing liquidity, and keeping prices stable. Yet most people have no idea how they work in detail. Market makers remain for many a black box; essential, but mysterious. Without them, markets would be chaotic, slower, riskier, and less efficient. You’d have to wait for a perfect match, when someone is selling exactly what you want to buy/sell, at the same time and at that very price.

In crypto trading, timing matters because when there is a delay from the time when an order is placed and when it’s actually executed, there can be a fluctuation in the price. These price changes are called slippage. Moreover, for tokens with limited market cap and for early stage projects operating in volatile, illiquid markets, even small transactions can move the price dramatically. In all these cases, a market maker provides (more) liquidity, ensuring there are ideally always buyers and sellers on the other side of your trade. That helps absorb price swings and keep things moving, making sure your token trades.

What are Market Makers?

Market makers are institutions or individuals who provide liquidity to financial markets which bridges the gap between supply and demand of the buyer and seller (this is called the bid-ask spread, by the way)! As noted, they are actors that work to stabilize exchange markets by ensuring that transactions can occur as quickly as possible and with minimal influences on the price. Put simply, “many market makers are brokerage houses that provide trading services for investors. They make markets in an effort to keep financial markets liquid” (Investopedia).

Market makers work oftentimes in tandem with exchanges. In some cases, an exchange uses a system where market makers compete. In this scenario, the market maker should set the best bid or offer so they can win the business of incoming orders. The competition affects price efficiency by lowering transaction costs, and it aims to capture the best bid-ask spread and trading volume. On the other hand, some exchanges, such as the New York Stock Exchange (NYSE), use a designated market maker (DMM) system. The DMM, also referred to as “specialists,” “are essentially lone market makers with a monopoly on the order flow of a particular security or securities” (Investopedia). DMMs are assigned specific responsibility for a security which obligates them to maintain fair markets and order flow.

This is also true for crypto, where exchanges and token issuers often contract market-making firms (sometimes called designated liquidity providers) under formal agreements. While not identical to TradFi DMMs in mandate or regulation, they serve a similar liquidity-provision function. However, a few key differences between the market makers in traditional financial markets in comparison to those in crypto markets arise, as well as market makers that operate through a decentralized versus centralized way. These will be discussed further in the types of market makers section of this article

Crypto Market Makers

We now turn to how market makers work with crypto exchanges. First of all, market makers are particularly important in digital asset markets. As the crypto markets are open 7/7 and 24 hours a day, the market faces more volatility and sometimes relatively lower liquidity, depending on the asset. There are both centralized and decentralized market makers that work in cooperation with crypto exchanges. For example, DMMs are typically contracted by exchanges or token issuers to provide liquidity. Generally, these parties agree on a formal contract that includes performance metrics and penalties.

Furthermore, the existence of numerous exchanges or trading platforms means that transactions through one platform have different effects on the price. In other words, the price for one asset may vary across exchanges, this is called price fragmentation. Indeed, when one particular exchange experiences more activity over another, the result is that traders are forced to accept a price that is not representative of the true market value of the asset. Consider this example:

There are two exchanges, which we will simply call X and Y. A token called $TOKEN has just been launched. If on exchange X, there is more activity then the price will experience more fluctuations compared to exchange Y. Then, there may even be a significant price difference of $TOKEN between exchanges X and Y. On exchange X, $TOKEN may trade for $8 while on exchange Y it may trade for $10. This is why market makers are so important to the crypto market. They help to reduce this price discrepancy and volatility. In the following sections, we will see how different types of market makers work with crypto exchanges, but first more on why this matters.

A Brief History of Market-Making

Market Makers have been around for a while and, as previously mentioned, they cater to both traditional financial markets and to the market for digital assets. Although the term “market-making” first emerged in 1962, arguably they have been around for much longer (Merriam-Webster). From Huobi Research, “traditional market-making first emerged in the early 19th century, and it has now become mature in development, diversified in trading varieties, and relatively stable in business model and return” (Market-makers: The Recluses through Cycles).

Early market makers started with mental math and manual inputting, yet as markets expanded, more institutions and investment banks joined into the market making business. With regulations and decimalization, spreads decreased significantly and competition increased as the world went through a gradual financialisation, prompting market makers to strive for increasingly innovative methods to obtain higher market share. Some of said innovation includes: upgrading algorithms, new risk management and compliance strategies, and, of course, the expansion into other markets such as crypto.

In cryptocurrency trading, market making takes on a new set of complications, and indeed, “there is a world of difference in terms of operations, technology, risk management and regulation” (Market-makers: The Recluses through Cycles) that a market maker should reckon with. Notably, the crypto market is smaller than traditional financial markets, subject to lower levels of liquidity and higher volatility. For market makers, this means considering higher risk potential. Moreover, due to the difficulty in regulating the crypto trading process, the relationship between projects, exchanges, and market makers becomes complicated. Besides, market makers don’t only exist on centralized exchanges (CEXs), but also on-chain through decentralised exchanges (DEXs), which further complicates the matter.

That said, we now turn to how crypto market makers actually work…

Market Makers Operations and Crypto Exchanges

To put it simply, market makers actively participate in the market by placing the best bid and ask orders; the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept for that asset. In this way, they narrow the bid-ask spread, making transactions more easily executed and prices consistent across platforms, reducing slippage.

The bid-ask spread is also where the market maker earns its profits. For example, say the bid price of a cryptocurrency is $3,000 and the asking price is $3,100, then if the market maker buys at the bid price and sells at the asking price, they profit from $100. Even when the bid-ask spread is in reality much narrower, the market maker can still experience significant gains thanks to the higher frequency of trades.

Market makers can make use of price discrepancies between crypto exchanges and take advantage of the arbitrage opportunity. And yet, by quickly tapping into these price differences, market makers help balance demand and supply back to the point where the price reaches equilibrium. The quoted price of the market maker thus arguably reflects the fair value of an asset based on real-time market conditions.

Now, this is key: market making is therefore all about facilitating trade rather than dictating the market. They don’t control prices and volumes, but rather provide the liquidity to more easily conduct transactions. This is also important because, in low-liquid markets, a larger transaction can lead to significant price swings, which may misrepresent the true value of a token.

Types of Market Makers & Their Strategies

Market making in crypto is certainly not an easy endeavor since we encounter “fragmented markets, low interoperability, low capital efficiency, regulatory uncertainty, and undeveloped exchange technology and connectivity” (Market-makers: The Recluses through Cycles). Therefore, certain market makers today deploy things like automation processes enabled by artificial intelligence (AI) and smart-contract technologies to help secure and make crypto trading more efficient. A variety of other techniques may also be used in their operations, including “algorithmic trading, arbitrage opportunities, and comprehensive risk management techniques” (Exploring The Role of Market Makers in Crypto). What about the role of bots in all this trading? Market-making firms often deploy algorithmic trading systems (bots) to analyze order book data, liquidity pool metrics, and market sentiment for trading decisions. Trading algorithms and market-making desks also interact with AMM liquidity pools to arbitrage price differences and rebalance positions. In “Market Making in Crypto Markets: How Bots Determine Prices,” Bitium Blog outlines four types of market making bots: Arbitrage Bots, AMM Bots, Order Book Bots, and Liquidity Optimization Bots. The article argues, interestingly, that much potential for bots lies in uncovering new trading strategies, especially where cross-chain interoperability and novel layer-2 solutions are introduced with time. The article also points to rising DAOs, suggesting they “could lead to community-driven market-making initiatives in which liquidity is controlled and incentivized by a decentralized group of users.”

Strategies deployed by market makers are thus evolving and context specific, but we’d argue that the fundamental operations and workings of a market maker in crypto is primarily distinguished between DMMs and Automated Market Makers (AMMs). To reiterate, DMMs typically sign formal contracts with exchanges or token projects, giving them greater flexibility in their strategies since they are not set to a fixed formula. Centralized exchanges often contract market-making firms (or “designated liquidity providers”) to supply liquidity under SLAs (Service Level Agreement). Some DEXs also have hybrid models that incorporate the off-chain order books of DMMs for tighter bid-ask spreads and prices.

On the other hand, AMMs, true to their name, operate in an automatic and permissionless way, through the use of liquidity pools. Users supply liquidity pools with crypto tokens, and as this happens the price simultaneously adjusts based on a pre-determined mathematical formula. Let’s look a little deeper into those.

Automated Market Makers & Liquidity Pools

In on-chain markets, traditional order books are replaced by a liquidity pool, a smart contract that holds balances of two tokens, such as ETH or USDC (Uniswap). For example, DEXs such as Uniswap, SushiSwap, and Balancer adapt the automated market model instead of order books. The automated model is pretty simple: liquidity providers (LPs) contribute assets to liquidity pools, and the exchange’s algorithm uses these pools to facilitate trades (Bitium Blog). In the liquidity pool, prices are determined by a formula which takes into account the ratio of assets in the pool. When trading, the user will simply swap one token for another directly through the pool, based on the algorithm of the liquidity pool. ‍

Having more liquidity accumulated (a “deeper” liquidity pool) ensures that the trade can happen since the supply is there. It’s not the protocol that predominantly benefits, although they may earn revenue through protocol fees. Rather, LPs are the ones that contribute to the pool and, as a result, receive benefits and potential rewards through traders’ swap activity. For example, LPs earn a portion of the trading fees (e.g., 0.3% per swap on Uniswap distributed proportionally based on their share of the pool, v2 default) (Uniswap Docs). On the other hand, LPs are also at risk of impermanent loss, which happens when the price of the deposited tokens changes. Although AMMs ensure constant liquidity, they can still suffer from price impact and slippage during large trades, especially in shallow pools. In sum, AMMs suit permissionless, on-chain environments where deterministic formulas provide liquidity, whilst the DMM places bids and asks that are based on live market conditions. Whilst automation and fewer intermediaries are of course much loved in the crypto space, we might add that DMMs are still a competitive alternative as they don’t rely on the accumulation of a deep liquidity pool and the locking up of this very capital that the AMM, on the other hand, requires. One thing is sure, markets almost never work perfectly, there are always improvements to be made or inefficiencies to be solved.

Choosing a Market Maker for Token Launches

When launching a token, projects must consider many factors, from functionality and scalability to marketing and community engagement. A key factor here is working with the right market maker, pre and post token launch. Not only does a market maker help to maintain a price where they are de facto backing a project, but additionally, it can provide performance data to the issuers that monitor the tokens trading volumes. Indeed, “even the most high-profile tokens can struggle without sufficient liquidity, leading to sharp price swings and delays in trade execution,” making the role of market makers a necessity, especially for tokens in their early stages (XBTO).

Truth be told: market makers have at times come under criticism for falsely increasing trading values and superficially increasing the worth of tokens, which is, of course, not the role of a market maker. Rather, they should encourage organic trading. In “Crypto Market Making: What It Is and How It Works,” it is indeed stated that one ought to, “be wary of makers who guarantee increased token adoption or promise to register specific trading volumes, as they may use unethical tactics like wash trading to meet targets” (AlphaPoint).

This topic was also taken up by Martin Pokorsi, Solutions Consultant at Enflux, a market making service infrastructure provider for token issuers, exchanges, and issuers. On LinkedIn, he writes, “There are market makers out there ‘painting’ your token’s future…. one fake green candle at a time”, and, “We’re [Enflux] not here to give investors a pretty picture to dump into. Real liquidity builds long term sustainability. [...] If your MM is more concerned with candles than fundamentals. Run. If you’re chasing green candles instead of healthy books. Pause and reassess everything! The projects that survive and thrive long term will do so without manipulated charts…”

With a somewhat decentralised market, the crypto space is subject to manipulation and, to put it bluntly, there is little that can be done to fully prevent this, at least not all the time. It’s not just crypto markets, but financial markets have always faced various schemes that don’t always play by the rules, or maybe they do, but not in the ways that we should accept. Finding the right market maker that fits with a Web3 project or business involves careful research and investigation, but can prove to be highly valuable in the successful execution of a token.

If we look at an article from Thrilld Labs, we explored fake and fraud investors in “Crypto Scams: How to Protect Your Web3 Startup from Fraudsters and Fake Investors,” and emphasized the importance of due diligence, which also very much applies to choosing your market maker. Cointelegraph noted that, green flag market makers are “‘white hat players’ who prioritize ethical practices and genuinely align their objectives with the success of the digital asset ecosystem” which is, as argued, crucial for “long-term visibility and [building] trust” (Binance Square). To identify these market makers, projects should understand their own needs, and assess each market maker's experience, technological infrastructure, adaptability, coverage and ethical track record in order to avoid common pitfalls.

Finally, take a close look at certain metrics, including: latency (the speed at which the market maker responds to changes in market conditions), execution speed (order fulfillment rate), slippage (proximity of final trade price to the expected price), order fill rate (completion percentage of order requests), and bid-ask spread and market depth (precision of bid-ask spreads and liquidity levels at various price points) (Binance Square). We would like to add that there can be many more factors to look at, but this is a good starting point.

Conclusion

To summarize, market makers provide liquidity for things like stocks or cryptocurrencies and they essentially facilitate smoother transactions. They “make” the market by ensuring that there’s always someone on the other side of a trade, which reduces bid-ask spread and makes the market more liquid.

In an ideal, perfectly competitive market, prices are determined solely by supply and demand. But market makers introduce a slight distortion by continuously adjusting their bid (buying price) and ask (selling price) in response to market conditions. Even though this is an “intervention,” it is not necessarily inefficient. This is because market makers often reflect market sentiments in their pricing. Particularly important, crypto markets experience relatively more volatile prices and fluctuations as well as decentralised, global markets. For both cases though, we have seen how different strategies and technologies are being introduced, from mathematical formulas and automated processes, to bots and DAOs. To be sure, with the rise of emerging technologies, market makers will also continue to evolve and change.

And finally, oftentimes market makers also act as partners for projects launching a token. The market maker can provide the stability needed in the early stages of launch, and lend credibility. Selecting the right market maker requires a process of due diligence, whereby the projects should consider a number of factors, including: the ethos and values, technological infrastructure, and track record of the market maker, seeking to uncover as many unknown unknowns as possible.

Resources (for the precise references and in-text links, consult the article on our website)