What is Market Making?
Jan 9, 2021 • 5 min read
Market making is the process of providing liquidity to securities, commodities, currencies and more recently crypto tokens in order to ensure that market participants (buyers and sellers) can efficiently transact at a fair price. Market makers are typically banks and large financial institutions, but smaller independent firms can also make markets. Cryptocurrency exchanges provide free access to their trading engines through APIs and this has allowed startups with limited resources to provide market making services. While not yet operating at the speeds seen in traditional markets, they are starting to catch up.
Short History of Market Making
In what is regarded as the earliest known source on modern stock exchanges, de la Vega describes the new entity and business as:
"This enigmatic business which is at once the fairest and most deceitful in Europe, the noblest and the most infamous in the world, the finest and the most vulgar on earth."
The Dutch East India company was the first to offer shares to the investing public in order to raise capital to fund its expanding business empire. As more and more companies joined the Amsterdam Stock Exchange the need for market makers to provide liquidity and thus stimulate economic growth became apparent.
These early market makers were merchants who had no particular opinion on whether the shares would go up or down in value. Their business model involved making a profit from selling shares for a tiny fraction higher than what they paid or buying for a little less than they sold. As de la Vega said:
"They consider their risk as much as their profit; they prefer to gain a little, but to gain that little with [relative] security;"
The difference between the price they quoted for a buy (the Bid) and for the price for which they were willing to sell (the Ask) is called the spread and it is this difference in price that drove their business model.
The world has changed a lot since the early days of the Amsterdam Stock Exchange, but the story largely remains the same. Companies often need capital to fund their expansion and investors are always looking for ways to earn a return. Market makers lower the entry barrier to the market as they ensure that investors can buy and sell shares at a fair price. Trust in the efficiency of the market makes it easier for companies (and governments) to raise new capital and market makers have certainly played their part in ensuring markets are liquid, transparent and efficient.
Market Making on Cryptocurrency Exchanges
The crypto markets have become much more efficient over the last few years. Gone are the days that large cross-exchange arbitrage opportunities would present themselves on a regular basis. Today, a crypto market maker operating on one of the larger pairs (e.g., BTC/USDT) will most likely have to co-locate with the exchange and will have to secure a fast fibre optic connection to a market moving price source in order to be competitive. Unlike some of their traditional market making counterparts they will have to deal with nascent exchanges whose infrastructure is not so developed and indeed often unreliable and they will need to operate 24/7 in markets that never sleep.
Centralized cryptocurrency exchanges employ the services of market makers in much the same way as traditional exchanges do. However, there is a new type of exchange which is uniquely crypto and that is the decentralized exchange (DEX). These exchanges employ an automated market maker algorithm that facilitates trading between assets on-chain. An example is Uniswap which regularly trades volumes that are close to that of Coinbase. While Uniswap only allows trading between pairs on the Ethereum network (ERC20 tokens), Thorchain facilitates multiple chains and makes it possible to trade native BTC for native ETH in a decentralized fashion for the first time.
A New Crypto Token’s Path to Getting Listed
As many as 10 new crypto tokens are launched every week. While a few years ago a new token project would launch on a centralized exchange platform, today many projects first list their token on a DEX. Getting up and running is permissionless and can be done with a few clicks. Assuming it is an ERC20 token, a project would simply become a liquidity provider and deposit ETH (or a stable coin such as DAI or USDT) and their new token to the liquidity pool. The creator of the liquidity pool sets the initial price of the token based on this split.
Despite the undoubted success of DEXs over the past couple of years, the majority of trading volume remains on centralized exchanges such as Binance and Kraken. Therefore, most serious projects look to list on a centralized exchange after an initial listing on a DEX (e.g. Uniswap, Sushiswap or Pancakeswap). As tokens expand and list on multiple centralized exchanges and DEXs, bots that seek out arbitrage opportunities between different venues ensure that prices are kept in check.
At margin we specialise in providing market making services for tokens on centralized and decentralized exchanges. We ensure you meet your liquidity obligations across multiple markets allowing you to concentrate on developing and growing your project.
To learn more about margin’s market making products,