By Stéphane Reverre & Chadi El Adnani @SUN ZU Lab
February 2024
[NB: See the glossary at the end of the article for a definition of technical terms]
Liquidity(*) is the gasoline of any exchange, whether traditional or crypto, and the engines pumping it are called Market Makers. We have provided in a previous article a rather technical view on the subject. Today’s approach targets a broader non-technical, non-financial audience, with a focus on token foundations and issuers.
Questions and comments can be addressed to c.eladnani@sunzulab.com or research@sunzulab.com.
What is Market Making (MM)? The case of the used car market:
Say you are looking for a car, and quite naturally, end up at your local dealership. Under normal circumstances, the salesman can offer a brand-new vehicle, or a used one. Those prices are “offered” prices: the salesperson is selling/you are buying.
Done deal: you get a used car, but unfortunately, realize 5 months later that it really doesn’t do the job. Too small, too big, whatever it is, you go back to the salesperson: “Hello, I bought a car from you 5 months ago, and it is not quite what I need. Can I sell it back?”. At this point, you may receive two different answers:
i/ “Sorry, I don’t have a buyer; let me call you back when I do.” In that case, you will be able to sell when a buyer comes along, not before. You may also look for a buyer yourself.
ii/ “Yes, of course, I’ll take it from your hands at …”. This price is a bid price i.e., the dealership is buying/you are selling.
The bid price will be lower than the original offer for obvious reasons (you drove the car for 5 months). Now, let’s assume, for the sake of the discussion, that you go back the day after your purchase. Will the salesperson bid the same price they offered the day before? Probably not. A bid will be lower than the offer price, if it is forthcoming.
The difference between bid and offer (also called the “ask” or “asking” price) is called the “spread”(*). In practice, this is the minimum profit margin the dealership will want to secure to offer the used car service. This margin exists for a number of reasons, but most notably because the dealership is taking a financial risk in carrying an inventory of used cars. Bottom line: the bid-offer spread is necessary to remunerate a risk. This is why even if you bring the car the next day, you will not get the offer price: the dealer takes a risk by accepting the car back, and a profit will be needed to pay for that risk.
Market Making in Finance:
The SEC defines a market maker as “a firm that stands ready to buy or sell a stock at public quoted prices.” A market maker (MM) is a professional trader who actively quotes two-sided markets in a particular asset, providing Bids(*) and Asks(*) for a given quantity.
There is, in practice, no difference between a financial MM and a car dealership (no kidding). The difference is in the asset: contrary to cars, stocks are fungible (i.e., perfectly identical for a given issuer), not subject to wear and tear, and not continuously produced, which means that the “second hand” market is very active (you cannot get a “brand new” share).
A car dealership will always provide an offer price for a new car because it is its primary business, the one from which it derives most of its revenues. The fact that it would provide a bid price for a used car depends on a number of factors, and no dealership will consider that it has an obligation to do so. To be clear, selling new cars doesn’t create a financial risk: the dealership takes a deposit, orders the car, and delivers it against payment when the manufacturer has shipped. Buying a used car means getting cash out, with the risk of getting stuck with a car that nobody wants.
Like the dealership, a MM may choose to participate in the market at all times or not, buying assets from sellers and selling them to buyers. MMs’ primary mandate is to provide liquidity, which ensures investors can trade quickly and at a fair price in all conditions. This creates a win-win situation where the MM earns profits for its services, and the overall market enjoys a certain level of liquidity, price stability and confidence. Evidently, MMs that decide to participate at all times carry a larger financial risk than those that do not. For a dealership, the level of financial risk is captured by the inventory of used cars waiting to be sold. This is exactly the same thing for the financial MMs.
It is essential to note that MMs have a mandate to provide liquidity (i.e. help investors trade better), but not to move the price. This is achieved by keeping MM obligations symmetric, with a bid AND offer price published simultaneously and a maximum spread, in all market conditions. Obviously, if a MM is stuck with too much inventory, its risk management may push for liquidation, which in turn may impact the asset price. However, this impact is not a primary result of the MM intervention; it is a consequence of adverse risk conditions (even if the risk results from poor management). Ideally, a car dealership will want to buy and sell used cars so quickly that its inventory remains near zero as often as possible. It’s the same thing for a financial MM: trading is rapid on both sides of the spread, and inventory is null at the end of every day.
In real life, two situations occur: extremely liquid assets/tokens that can be easily bought or sold without causing significant price impact, and less liquid assets/tokens that experience substantial price swings every time a sizeable trade is executed. MMs are extremely useful in the second case.
Liquid asset: BTC-USDT on Bitstamp
Source: SUN ZU Lab Live Monitoring Dashboard
Let’s take Bitcoin (BTC) as an example of a very liquid asset. The lowest number in red represents the best Ask/Offer (the lowest price at which sellers are willing to sell, on this specific exchange, at the moment). In contrast, the highest number in green represents the best Bid (the highest price buyers are willing to offer for Bitcoin), the difference between the two is the Bid-Ask spread (4 USDT or 0.916 bps). We can see on the last column (cumulative $ USDT sell/buy order amounts at each level) that a $11K (USDT) spot buy order would leave the best Ask at 43,671 USDT, moving the mid-price by a mere 3 USDT to 43,676, and the new spread to 10 USDT or 2.3 bps. This would be a temporary situation as market participants would move quickly to fill this gap and bring the spread back to previous levels.
Illiquid asset: POLIS-EUR on Kraken
Source: SUN ZU Lab Live Monitoring Dashboard
In the case of POLIS-EUR as an example of an illiquid asset, a €1000 sell order would move the best Bid down to €0.301, creating a €0.027 spread, or a whopping 8.6%!
The business of Market Making:
In TradFi, there are situations where market-making is voluntary and optional, and others in which it is self-imposed or even constrained by a contract. There are, for example, many hedge funds running “statistical arbitrage” strategies that are akin to voluntary market-making. The strategy stands ready to buy and sell in the market with a certain spread, and doing so will (hopefully) generate trading profits without too big an inventory. But if you want to become a registered MM with certain privileges, you must commit to continuously quoting prices. Examples of that abound in Europe; most electronic exchanges have MM programs for specific products: in exchange for a commitment to provide liquidity, MMs will enjoy reduced fees or sometimes outright payments. Under those commitments, MMs must quote a minimum volume at a maximum spread, and stick to those parameters at all times and during all market regimes.
When MMs operate under a contract with an exchange, they will often benefit from specific technical provisions: typically, the exchange will implement a “market maker protection,” which essentially cancels all orders (at once) from a MM when violent price moves occur. There are also different modalities for order management (for example, a “bulk order” capability, whereas regular investors can only send single orders, one at a time). Those features incentivize MMs to stay in the market even when volatility rises (i.e., when they are most needed) by offering privileged risk management tools.
As an industry, market makers earn the ‘spread’ between bid and ask prices because they accept to carry inventory risk. When the spread is contractually set, their profit margin is mechanically constrained.
In today’s highly competitive markets, the bid-ask spread is often razor thin (0.1 to 1 bp for Bitcoin on leading centralized exchanges). To remain profitable, a market maker must price assets quickly and accurately, be able to execute trades at scale, and manage its inventory properly.
Inventory risk is indeed the most important risk here. You have to have some to fulfill your obligations (what if a buyer comes asking for some?), and yet it is subject to price movements. Too much of it will cost if prices are going down, and too little may prevent you from fulfilling investors’ demands. Incidentally, this risk is even more pronounced in crypto markets, where prices are more volatile.
The Importance of Market Making:
Liquidity & Depth
Market makers make it easier for investors to buy or sell an asset quickly or in large volumes. In financial terms, they deliver liquidity and depth to the market.
Attracting and concentrating the asset’s tangible volume is crucial – as opposed to engaging in practices like wash trading (*), layering or spoofing(*), which attempt to create fake or misleading volume. This distinction is significant in maintaining ethical financial practices and building investors’ trust. Market makers play a vital role in this, as their ability to optimize liquidity directly impacts the organic volume and, in the end, investors’ confidence.
Insuring New Token Launch Success
New tokens are usually not widely known after their initial listing on exchanges and may suffer from a limited community of buyers and sellers, making it challenging for market participants to find each other and agree on a price. This is where MMs are extremely important to tighten the spreads, buying from sellers and selling to buyers at prices they both deem fair and acceptable. We covered in a previous article how the Worldcoin team relied on five MMs during the launch phase to ensure “sufficient liquidity for WLD traded on centralized exchanges outside the US, to facilitate price discovery, and to enhance price stability of WLD.”
Greater Price Stability and Lower Volatility
Market makers’ presence streamlines the execution of trades, reduces fluctuations in prices, and dampens supply and demand gaps. These activities build confidence among market participants. Market makers help ensure that markets function reliably and remain resilient even during times of turbulence.
Enforcing Price Coherence across Venues and Products
Crypto market makers can play a role in mitigating price discrepancies between different exchanges or instruments. They continuously quote buy and sell prices across different venues and related instruments, thereby strengthening market integration.
How to choose your crypto Market Maker:
Because of their role in providing liquidity, MMs have an important role to play in the crypto ecosystem. Yet, bulletproof standards have not found their way into the marketplace, and stakeholders are not necessarily well protected – without even being aware of it. When choosing a MM to contract with, the most important questions are often those that are not even on the table. You know, the old adage: “What should I ask that you are not telling me?”
Here are, in our views, a few important considerations and certainly questions for which you should be getting answers – or your money back:
- Consistent spreads & deep order books: “How do I know that you are in the market when you are needed and at the very least when you are supposed to?”. We view this as the single most important question a MM should answer. There are four fundamental characteristics of a well-formed MM contract: size, spread, time, and symmetry. A professional MM will provide prices for a given symmetric size and maximum spread with a minimum presence (say 90% of the time, measured with 12- or 24-hour intervals). Token issuers often do not have the financial knowledge to assess MMs’ actual impact on liquidity. MMs provide reporting on their activity, but isn’t that the left hand evaluating the right one? An independent assessment is the best way to go, and any serious MM will agree and diligently accept third-party assessment of contractual KPIs. Today, few actors in crypto are able to provide transparency on whether Market Makers are actually doing their job – SUN ZU Lab was created to answer that question.
- Risk management: “How do you manage your inventory?” MMs have full latitude to manage their risk as they see fit, but accumulating undue inventory may create tremendous selling pressure if liquidation occurs suddenly. In fact, it’s a double whammy: if a sharp fall in price forces a MM to liquidate a sizeable inventory, it will only add to the overall sentiment of panic. Best practice suggests an inventory risk under control and within reasonable limits (whatever they are). As a token issuer, you don’t care about MMs inventories, but certainly, you care about the possibility of a massive downward shock if those inventories accumulate too much or too fast.
- Reputation and business ethics: “How do I know that you will not engage in manipulation or other deceptive practice at the expense of token holders?” Well, crypto being unregulated, MMs can do on the side whatever they want. But at the very least the issue of reputation and fairness should be put on the table, and commitments should be made.
- Profitability: “How much trading profit do you make?” This one is a hard transparency question, and not all MMs may want to answer. Being constrained, a MM may not always make a trading profit. On average though, trading profit plus contractual remuneration should add up and be positive. Yet, too much profit means that the contract is unbalanced.
Glossary:
- Market Maker (MM): The SEC defines a market maker as “a firm that stands ready to buy or sell a stock at public quoted prices.” A market maker (MM) is a professional trader who actively quotes two-sided markets in a particular asset, providing bids and asks for a pre-defined quantity.
- Bid: The highest price a buyer is willing to pay to purchase a security or financial instrument. It represents the demand side of the market, and market makers provide bid prices at which they are willing to buy securities from potential sellers.
- Ask: The lowest price at which a seller is willing to sell a security or financial instrument. It represents the market’s supply side, and market makers provide ask prices at which they are willing to sell securities to potential buyers.
- Bid/Ask Spread: The difference between the highest price (bid) a market maker is willing to pay for a security or financial instrument and the lowest price (ask) at which they are willing to sell. From an investor viewpoint, the spread represents the cost of trading while it can be seen as a (maximum) profit margin for market makers.
- (Market) Liquidity: Is defined as the ability to buy or sell large quantities of an asset without significant adverse price movement.
- Market Depth: The measure of the quantity of buy and sell orders at different price levels for a security or financial instrument. Market makers closely monitor the market depth to assess supply and demand dynamics, adjust their bid and ask prices accordingly.
- Order Book: A digital record of all outstanding buy and sell orders for a security or financial instrument, organized by price level. Market makers use the order book to gauge market sentiment and make pricing decisions.
- OTC (“over the counter”): refers to a type of trading where parties negotiate terms privately. It is opposed to an “organized market” where trading is governed by standardized instruments and rules, and trading is often anonymous.
- Quote: A market maker’s bid and ask prices for a security or financial instrument. Quotes are typically displayed on electronic trading platforms and reflect the market maker’s willingness to buy or sell at those prices (for a given quantity).
- Arbitrage: The practice of taking advantage of price discrepancies in different markets or instruments to make a risk-free profit. Market makers may use arbitrage strategies to capture slight price differences between trading venues or related securities.
- Wash trading: A form of market manipulation in which an entity simultaneously sells and buys the same financial instruments, creating a false impression of market activity without incurring market risk or changing the entity’s market position.
- Spoofing: A term used to describe a form of market manipulation where traders place a Bid or Ask order with no intention of fulfilling it, instead canceling it before execution, with the sole intention of manipulating markets in a certain direction (up or down).
Disclaimer
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About SUN ZU Lab
SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring transparency to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboards & API streams or customized reporting. SUN ZU Lab provides Token Issuers & Market Makers with institutional standard actionable data solutions to improve the transparency and fairness of Crypto markets.
