Many people think of market makers as the big bad wolf of the crypto markets. So let’s explore if there is some truth to that. When you scroll through social media you will soon recognise that the term market maker is often used to refer to big and sketchy dark forces that manipulate and control the prices and act in the background pulling strings, while retail investors suffer from their activities.
What is a market maker actually doing?
Another term — that might describe the job of a market maker better — is liquidity provider. What that means is that the market maker ensures that there are enough “offers” on the buy and sell side of a specific asset market.
To explain this a bit better let’s look at an example. Whenever you’re on an exchange and have a look at the order book of a certain trading pair you will see something like this:
On the left there is the buy side, on the right the sell side. The colored graphs show the so-called order-book depth. In our above-mentioned case, this would indicate that — at around 9,700$ — there are limit buy orders logged that sum up to a total of 70 BTC. The lower the price in the order-book, the more orders (and therefore more Bitcoins offered) there will be. The same, but vice versa, is true for the sell-side. A liquidity provider’s (market maker’s) job is to simply place orders on both sides of the order-book, thereby providing liquidity. What does Liquidity actually mean? Essentially, it’s a term that can be described as follows: If someone wants to buy or sell a coin/token, they can easily and quickly do so, while at the same time the risk of paying a substantial premium due to wide spreads is avoided.
The spread is defined as the difference of the price of the highest order on the buy (highest bid) and the price of the lowest order on the sell side. (lowest ask)
Therefore creating a more stable exchange and price environment for all parties involved.
The second, big part of a market maker’s job is to keep the spread tight. The spread is defined as a difference between the highest bid and the lowest ask in the books. (bid=buy side, ask=sell side). We will take a much deeper dive into these mechanisms and how they’re being handled in the upcoming articles of this series.
So why is that actually important?
If a trader wants to buy or sell an asset (with a market order) he or she needs to match an existing order and wants to get a price that is close to the last market price.
For getting a price close to the last market price a tight spread is key.
The New York Apple Exchange (NYAE)
To illustrate that, we will use this fictitious example. Alice and Bob want to trade apples at the famous NYAE. We have an illiquid market, because we have 4 orders on the buy side and only 3 on the sell side.
Alice is lucky — She found the opportunity to market sell her apple at 0.54$. Now that Alice sold one of her apples, the order at 0.54$ is erased from the order book and there is a spread of 0.15$ between bid and ask. This almost makes a 38% difference percentage-wise. Now that Bob wants to market sell his two apples he can only get an average price of 0.325$.
What a market maker would do is adding enough apples on the buy and the sell side with enough depth in the order book so that there are enough offers on the market for retail traders to buy and sell their apples.
Bob is happy now since he gets a better price for his apples, Alice can re-buy 10 apples at about the same price and the market maker is happy since he makes money by earning the little difference between bid and ask. (e.g. A sale of 2 apples at 0.54$ and a purchase of 2 apples at 0.55$a → That results in a profit of 2 x 0.01$ = 0.02$)
Is everything really as positive as it seems?
Obviously nothing in the world is only positive. Especially in crypto, where ethics sometimes might not play the biggest role, there are cases where a market maker can harm both retail investors and/or a market in general.
Since market makers are mostly big fish in a market, they can use their capital to artificially boost one side of the market. In order to avoid that, transparent monitoring is needed. Furthermore, market making is sometimes misunderstood and used as a term for generating huge amounts of fake volume (sometimes 10 MM$ and more). When in fact, this has nothing to do with actual market making.
This will soon come to an end anyway, as described in our last article
The term market making is often used in a rather negative way, when in reality — if done correctly — it is actually essential for illiquid markets in order to ensure that buyers and sellers can match their orders.
Especially, smaller tokens/coins that suffered a lot from the bear market see very low liquidity in their markets and would therefore greatly benefit from professional market making.
Plus, with CoinMarketCap’s recent announcement real market making will become more important than ever.