Cryptocurrency

Crypto Market Makers - Who Are They And How Do They Work?

December 16, 2022
5 min

Who Is A Market Maker?

A market maker is a firm or individual that buys and sells securities directly from other market participants. They provide bids and offers for securities while providing liquidity and market depth for participants.

Think of market makers as the “warehouse” company for securities, they “keep inventory” of stocks so that when people want to buy or sell a security, they can do so almost immediately. 

This might sound like something your broker does for you - but don’t confuse one for the other. It just so happens that many brokerages are market makers as well. 

By definition, a brokerage company is a middleman organization that connects buyers and sellers to complete market transactions. A market maker, on the other hand, is a participating party in the transaction – acting as either a buyer or a seller.

How Do Market Makers Work?

Market makers are companies required to constantly quote prices and volumes at which they are willing to buy or sell a security. They simultaneously post a bid and ask for a stock so that the retail trader (that’s you) could transact at that price. 

The market maker will do this constantly throughout the day and in doing so, provides liquidity for the retail traders.  Market Makers apply an area of probabilities called control theory and the stochastic process to understand and model the random changes in the markets.

How Do Market Makers Make Money 

In return for this service, market makers can profit in two ways:

1. The Bid-Ask Spread

When trading a security or asset, have you ever noticed that the buy and sell price are almost never the same? The difference in these two is known as the spread. A market maker can make a profit off of this spread by collecting the difference. If a market maker were to post a bid at $1.00 and offer an ask at $0.95 for 100,000 shares each, the maker would stand to earn $0.05 on each share for a $5,000 profit.

2. Buying and Selling

Like every other investor, a market maker also earns a profit through price appreciation. During falling markets, for example, market makers take on risk by being the purchasing party of many transactions. If things calm down, the market maker can slowly unload their holdings at more favorable prices.

Who are the Market Makers in Crypto

The market makers in crypto trading have deep and intensive experience in investment banking, statistics, and quantitative analysis. While the cryptocurrency market traders can be anyone from institutional traders to banks, or brokerage houses to exchange protocols,  the predominant market makers fall under one of two umbrella categories: the humans and the robots.

Here’s a quick breakdown of both categories:

Humans

When we say human market makers, we mean the professional traders that operate under a special license to provide liquidity to the markets and make a profit off the spread. These are your institutional or individual traders that perform trades at a high-frequency, never hold positions for more than few minutes, and make anywhere from 0.01% to 0.10% per transaction. 

Make no mistake, human traders are just as capable as their programmed counterparts. They use quantitative models to make decisions and what you give up in speed and convenience, you make up for in flexibility. Whereas market making bots are pre-programmed to react a certain way, human market makers can adapt and thrive in difficult environments.

Bots

Automated Market Makers are a type of Decentralized Exchange Protocol that relies on a mathematical formula to price assets. Decentralized Cryptocurrency Exchanges (DEXs) all use an automated market maker as they remove the need for third parties and centralized authorities to provide market liquidity.

Market making bots are advantageous in that they’re capable of rapidly reacting to changes in the market before other investors will. On top of this, they offer retail traders with more income stream options, such as yield farming.

Without human intervention, however, automated market makers are susceptible to trading losses taken on due to large amounts of volatility within a trading pair. 

What’s the Market Maker’s Impact

“Market Makers manipulate the market”

Market manipulation is a very common misconception that retail traders have about market makers. Disingenuous market makers promise project owners a price target or trading volume, some even take it one step further and promise ICO issuers that their token’s price would appreciate to a specific price. Because many crypto market makers aren’t regulated, market manipulators don’t get punished. This practice, however, hurts the market in the long run. 

But, if market makers aren’t there to manipulate the markets, what do they actually do?

Here are the two roles of cryptocurrency market makers:

Liquidity

Interestingly enough, anyone who’s been involved in the crypto space will already know what a market maker does – you probably just call them by a different name: liquidity provider.

As a liquidity provider, crypto market makers ensure a smooth transaction process for buyers and sellers. Without their participation, the liquidity and volume of any given security would drop – providing the investors confidence that they can always quickly sell or liquidate their holdings.

Without liquidity, investors, institutional and retail alike, would be dissuaded from holding a position, and the overall market wouldn’t reflect the “true” pricing of a security given that there is always someone willing to buy and sell at the same time.

Income Stream Options 

The cryptocurrency world offers an interesting means to earn income: yield farming.

Liquidity provider tokens are proof that you own a piece of the liquidity pool you’ve staked your assets in. By investing into a liquidity pool, you receive LP tokens and an annual percentage return in the form of interest rates. In some cases, investors could earn extra based on the liquidity pool’s transaction fees. Depending on the market maker you’ve invested in, your rate of return will differ – just be careful in investing into small liquidity pools that may face smart contract failures and foreclosure.