Abstract

Traditional market-making first emerged in early 19th century, and it has now become mature in development, diversified in trading varieties, and relatively stable in business model and return. As critical as it is in the financial market, market-makers have provided unparalleled liquidity and efficiency to the market. As the market continues to expand, more and more institutions and investment banks have joined the market-making business, which has become an irreplaceable revenue stream. The overall market-making business is dense on the top, and the competition is intense. In order to obtain higher market share, market-makers are continuously upgrading algorithms, technology, risk management and compliance, and the scope has been extended to the crypto world.

Although the market-making business in crypto is not inherently distinct from that in traditional finance, there is a world of difference in terms of operations, technology, risk management and regulation. First, by scale, the crypto market is still relatively small compared to the traditional financial market, and so are the market-makers. The crypto market is volatile with relatively low liquidity level, market-makers have to be more meticulous and apply higher level of risk management. Second, market-makers in the crypto market are also known as the house. Since the trading process in the crypto market is difficult to be regulated and there is no strict code of conduct to be enforced on market-makers, the relationship between exchanges, project parties and market-makers becomes quite complicated. As a result, the market-making business does not only exist on CEXs, but also on-chain, which lays a foundation for some middleware and protocols to provide services to market-making activities. Last but not least, in terms of technical architecture, higher technical capability is desired to ensure the security of transactions in the crypto industry.

The market-making business in the crypto world is a Blue Ocean market that is full of opportunities yet with risks lie within. Currently, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in the United States are tightening regulation on the crypto market so that many institutions and businesses are being affected. What’s worse, under the bear market, it was frequently seen crashes of large institutions, posing a stronger challenge to market-makers on their risk management capability. In addition, crypto market-makers are also exposed to fragmented market, low interoperability, low capital efficiency, regulatory uncertainty, and undeveloped exchange technology and connectivity.

Even so, room for development and profitability remain considerable for market-makers. Crypto market-makers will look more like market-makers in traditional finance in the future by demonstrating the following characteristics:

For potential investment, centralized small market- making strategies or service-oriented projects, tools that address interoperability, and CeDeFi projects are worth some attention.

1. Traditional Market-making

A market-maker is an institution or individual that provides liquidity in the financial markets; the main responsibility is to provide liquidity and market depth to the securities trading market. Market-makers usually trade between buyers and sellers in the securities trading market and provide quotes in the market so that other traders can trade on that quote to buy or sell. Market-makers are usually made up of investment banks, securities firms or professional organizations that play an important role in the market and foster market stability and liquidity. Market-makers typically trade in one or more markets simultaneously and provide liquidity by buying and selling the same asset in order to provide trading opportunities for market participants.

A market-maker’s main goal is to profit from spread when asset prices fluctuate, therefore, algorithms and other techniques are normal tools for market-makers to analyze the market, identify opportunities, and conduct trading activities in a short period. Market-makers may trade in a variety of markets, including stocks, foreign exchange, commodities, and bonds.

1.1 Industry Overview

1.1.1 Industry functions and clients

The role of market-makers in financial markets is crucial and distinct from other market participants, especially in providing liquidity and market efficiency. Specifically, market-makers perform six main duties:

Major types of clients for market-makers include the following:

1.1.2 History of market-making

The development path of market-making can be divided into five phases:

1.1.3 Market size and competitive landscape

According to FINRA (Financial Industry Regulatory Authority), the regulator of financial industry, the number of legal market-makers registered in the United States exceeds 500 as of September 2021. These market-makers are regulated by FINRA. According to the Office of the Comptroller General of the Currency (OCC), the total combined revenue from transactions by holding companies of U.S. commercial banks remained at the level of $50 billion from 2012–2018 despite a year-over-year decline in trading revenue in some special years represented by 2018, which is dragged down by secondary market conditions, the fluctuation is relatively small and a trend of growth is spotted. The banking industry has seen further growth in revenue from transactions since 2019, the combined revenue by holding companies of US commercial banks in 2019, 2020, and 2021 is $75.126, $79.512, and $78.946 billion, respectively. The size, or market share, of a market-maker firm is often related to the extent to which it provides liquidity in that market, specifically, the market share of a market-maker can be measured by several metrics:

In all, the market share of market-makers is an important indicator of their performance in terms of trading activity, liquidity provision and trading efficiency in the market.

Some of the more prominent market-maker firms are as follows:

1.2 Prerequisites for a Market-making Company

Establishing a market-making firm is difficult because it requires a high degree of financial strength, technical capability and market insight, as well as the need to meet the regulatory requirements of financial regulators and the ability to survive a highly competitive market and high-risk management pressure.

1.2.1 Understand the market

Market-makers need to have an in-depth understanding of market rules, liquidity, trading varieties and behavioal patterns of traders in order to make the right trading decisions. They must be able to capture the trends and opportunities in the market in order to gain an edge in the market. There are several ways to understand the market.

(1) Researching market information and data: Market-makers need to research historical and current market trading data in order to understand the market and price fluctuations. Market-makers can obtain market information through the use of trading software or via market data providers.

(2) Tracking news and events: Market-makers also need to be aware of market-related news and events, such as reports from companies, political situations and macroeconomic data. This information may have an impact on market prices and help market-makers make better decisions.

(3) Communicating with other traders: Market-makers can learn about the market by communicating with other traders. For example, they can attend trading conferences or webinars to exchange views on market developments with other traders.

(4) Adopting trading strategies and models: Market-making firms may use trading strategies and models to predict market trends and price movements. These models may include methods such as technical analysis, fundamental analysis and quantitative analysis.

1.2.2 Establish a technological platform

An efficient and stable technological platform that could support real-time trading and data analysis is a must for market-makers. The platform needs to include algorithms for instant trade execution, high-speed data transmission and processing, and secure trade settlement. Specifically, market-making firms must possess the following five types of technology:

(1) Trading technologies: for securities, futures, options, etc., including the use of trading platforms, order management, risk control, etc.

(2) Data analytics: for getting a gist of market sentiment and trends, including data mining, machine learning, artificial intelligence, etc.

(3) Quantitative trading: enabling high frequency trading and instant trading, including algorithmic trading, high-frequency trading, programmed trading, etc.

(4) Risk management: ensuring the safety and stability of trading, including risk control, money management, market monitoring, etc.

(5) Software development: developing and maintaining trading systems and trading tools, including programming languages, database management, software testing, etc.

1.2.3 Determine capital requirements

Market-making firms require significant capital to support trading activities. The amount of capital as well as the source of capital must be identified prior to entering the market. Here is how to determine how much capital will be needed:

(1) Calculate market liquidity requirements: Market liquidity requirements are the amount of capital that market-makers must provide in order to make buy and sell transactions in the market. Methods for determining liquidity requirements include measuring indicators such as market trading volume, trading frequency and position size to estimate the amount of capital to be invested.

(2) Consider margin requirements: Many exchanges and markets require market-makers to provide a certain level of margin to ensure that market-makers are compliant with their trading rules in the market. Extra funds must be prepared to meet the margin requirements.

(3) Consider transaction costs: Transaction costs are the fees market-makers need to pay for trading in the market, including commissions, quote spreads, clearing fees, etc. The transaction costs must be taken into consideration when budgeting.

(4) Consider market volatility: Market volatility can cause market-makers to suffer losses. Sufficient capital must be reserved to cover market volatility.

In summary, determining how much capital a market-maker needs requires a variety of factors to be considered, and it needs to be analyzed and calculated on a case-by-case scenario. What’s worth noting is that capital requirements are a dynamic process; it needs to be constantly adjusted based on market changes and business expansions.

1.2.4 Implement risk management

Market-makers need to manage risk in order to ensure the safety and stability of trading. A risk management strategy that includes trading risk, liquidity risk, market risk and operational risk must be effective.

Market risk management is to ensure that trading activities remains on track despite the market condition is favorable or not. For example, market-makers may use hedging strategies, leverage controls and trading restrictions to manage market risk. Operational risk management is to confirm that no errors or mistakes are made in the trading process. For example, market-makers can manage operational risk by establishing good trading processes and trading rules, and by strengthening measures such as internal auditing and monitoring. Technical risk management is to eliminate the possibility that the stability and security of the trading system is undermined. For example, market-makers can adopt backup and recovery strategies, network security measures and data encryption to mitigate technical risk. Credit risk management is to prevent issues such as default or loss of non-performing assets from occurring during the trading process. For example, market-makers can employe credit assessment and monitoring, margin management and risk control to lower credit risk.

1.3 Operations and Market-making Mechanism

On a trading platform, market-makers provide liquidity through two-way quotes (buy and sell), which can be generally divided into the following steps.

(1) Select the target: choose one or more markets or products, such as stocks, futures, foreign exchange, etc., based on trading strategy, cooperation model and level of risk aversion.

(2) Analyze the market: analyze the selected market or underlying assets to understand characteristics, trends and changes, and assign the corresponding strategy based on the analysis.

(3) Provide quotes: Market-makers will provide two-way quotes, i.e., buy and sell quotes, to provide liquidity based on trading strategies and market conditions.

(4) Acceptance of trades: Market-makers will accept buy and sell orders from clients and place orders based on their own quotes. In some cases, market-makers may hedge to reduce risk.

(5) Risk Control: The market-maker will monitor and control the trading risk and perform risk management and hedging operations as needed.

(6) Profit: Market-makers make a profit through trading spreads and fees, but there is also the possibility of leading to losses.

Under the above operation model, there are two kinds of driving mechanisms: quote-driven and order-driven. The quote-driven mechanism is a counter-offer system in which market-makers provide investors with bilateral quotes for buying and selling, leading to changes in transaction prices through the updating of quotes. The order-driven system, also known as the bidding system, allows investors to transmit their buy and sell orders to the exchange through the internet, and the exchange’s computer hosts will aggregate buy and sell orders according to the priority principle of time and price to form a continuous transaction price.

1.4 Profit Model

The profit model of a market-maker is usually based on the bid/ask spread. A market-maker will quote both a bid and an ask price on the trading platform, called a “two-way quote”. When a customer places an order, the market-maker closes it instantly and then sells it at a higher price or buys the same security at a lower price, earning a profit from the spread, which is often called Spread revenues or Facilitation revenues. Market-makers can also make profits through high-frequency trading, hedging, and arbitrage. Among them, high-frequency trading is a trading strategy that uses high-speed algorithms and automated systems for instant trading. Hedging is the use of opposite trades to reduce risk, and arbitrage is the use of different prices in the market to absorb profit. In addition, market-makers have an inventory revenue, which reflects the gains and losses from changes in the value of securities and holding gains such as dividends and interest while the market-maker maintains the position.

The level of profitability usually depends on factors such as market volatility, liquidity and size of trading. With a stable market and sufficient liquidity, market-makers are usually able to make substantial profits.

The profitability of market-makers also requires consideration of transaction costs. The cost structure of market-making is constituted by 3 components: transaction cost, such as brokerage commissions and clearing fees paid when buying and selling securities, financing cost incurred from raising capital for market-making, and costs associated with risks, such as hedging to reduce risk exposure to assets held, and value at risk (VaR) from implacable credit risk and counter-party risk. However, because market-makers typically initiate a large number of transactions, transaction costs can be reduced by economies of scale and effective technologies.

Spread earnings are the main earnings of market-makers. According to publicly available data, most market-makers are relatively stable in terms of profitability, but the margins are not high.

1.5 Regulatory and Compliance Requirements

Market-makers are directly involved in the liquidity and price formation of the securities market, and their trading strategies and behaviors may have an impact on the market, hence, market-makers have to be regulated. Regulation can effectively ensure that market-making firms comply with trading rules and market order so that market manipulation and improper trading practices can be prevented, the interests of investors can be protected, and fairness, transparency and stability of the market can be achieved. At the same time, regulation can also promote the compliance level of market-making firms, strengthening the requirements of risk management and information disclosure, improving market confidence and transparency by reducing market volatility, and fostering the healthy development of the market at large. Therefore, market-makers should be regulated not only for the best interest of investors, but to ensure the healthy order of the overall market.

This article focuses on the regulations of market-makers in the US. In the United States, regulations on market-makers are relatively strict. These firms are required to fully comply with regulatory requirements of the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), as well as other securities regulations. In addition, market-making firms are subject to compliance and anti-money laundering requirements. The regulators closely supervise trading and business activities of market-maker firms, including review of trading systems and algorithms, examination of risk control mechanisms, and the requirements for data protection. In terms of regulation, the U.S. securities market is well regulated, and penalties are imposed for violations; market-making firms need to pay extra high attention to compliance in daily operations. The specific regulatory bodies and laws are as follows:

1.6 Future trends

Market-makers are side products by the maturing financial market, which has now been irreplaceable in the market. With the development of financial markets, the market demand for market-makers will continue to exist. However, at this stage, the market is complete and saturated, new institutions will find it difficult to enter, and they instead turn to the crypto market as the main battleground.

In general, market-makers will face the long-term challenges as the follows:

(1) Technical risk: As the market continues to change, market-making firms need to continuously upgrade and improve their technical architecture to ensure stable system operation and avoid losses caused by technical problems.

(2) Legal risk: Market-making companies need to comply with the laws and regulations of each country, including financial regulation, securities laws and intellectual property rights, otherwise litigations and losses may occur.

(3) Market risk: Market changes and uncertainties will pose risks and challenges to market-making firms, such as market volatility, declining trading volume, and lack of liquidity, all of which can affect the profitability of market-making firms.

(4) Competition risk: As market competition intensifies, market-making companies will face competition from other market-making companies and emerging technology companies; core competitiveness must be continuously enriched to maintain market position and profitability.

(5) Operational risk: Market-making firms need to handle a large volume of transactions and data and need to establish effective risk management and internal control systems to prevent risks and losses resulting from internal operational errors or irregularities.

Opportunities and challenges coexist. As global financial markets continue to evolve, the complexity and size of securities market transactions continue to grow, market-making firms will have more opportunities to participate in the market by providing liquidity services and market-making for higher profits. What’s more, with the rapid development of the crypto market, market-making firms are also exposed to more opportunities by providing market-making services and liquidity provision for crypto assets. At the same time, market-making firms can improve market-making capabilities by developing and applying new technological tools and algorithms to better adapt to market demand in order to earn more market share.

2. Crypto Market-makers

Market-makers in the crypto industry are not much different from traditional finance in essence: they both provide liquidity to the market, open and close positions instantly, and make profits out of bid-ask spreads. However, there is a world of difference in operation mode, technology, risk management and regulation. Firstly, in terms of market size, the crypto market is relatively small compared to the traditional financial market, and the crypto market-makers are also relatively small. Secondly, the crypto market is relatively less liquid and more volatile, so market-makers need to be more cautious on risk management; furthermore, market-makers in the crypto market are also the house. Because the trading process in the crypto market is difficult to be regulated and there is no strict code of conduct of market-makers to be enforced; last, in terms of technical architecture, the crypto industry mandates higher technical capability to ensure the security of transactions.

Market-makers are vital in the crypto market for (1) providing liquidity and depth to the crypto market and (2) maintaining stable price level in the market to attract more traders. In other words, market-makers are the ones who keep the crypto market function properly so that project owners, exchanges, and investors can fulfill their rules properly.

2.1 History

The development path of market-makers in the crypto markets can be divided into 3 phases:

(1) Initial phase (2009–2012): With the birth of Bitcoin, the first batch of cryptocurrency exchanges and market-makers began to emerge. These market-makers were mainly made up of individuals and small teams and were designed to provide liquidity and trading opportunities.

(2) Development phase (2013–2017): As the cryptocurrency market continued to develop and mature, more and more institutions began to be involved, cryptocurrency exchanges and market-makers became the focus of major institutions as time goes by. During this period, some professional market-makers appeared and started to provide more specialized and efficient services. Some representative companies that emerged during this period included Cumberland Mining, Jump Trading, DRW Trading, and others. These companies not only provide market-making services, but also offer a variety of services such as arbitrage and asset management.

(3) The catastrophe phase(2018-present): the crash of cryptocurrency market in 2018 led to the collapse of many exchanges and market-makers, but it also brought an opportunity and reshuffle to the market. After consolidation and adjustment, the trading volume of the cryptocurrency market gradually recovered, and the services and models of market-makers continued to be optimized and upgraded. At the same time, with the continuous introduction and improvement of policies and regulations in various countries, regulations and compliance of crypto market-makers have hence become the everlasting topic in the market. At this stage, some traditional financial companies started to get involved in the cryptocurrency market, such as Jane Street, Susquehanna, etc.

At present, the scope of crypto market-makers is not only limited to inside exchanges, but also expanded to areas such as OTC and decentralized exchanges, providing critical support and protection to ensure the development and maturity of the market.

2.2 Operations

Crypto market-makers operate in a similar fashion to traditional financial market-makers, primarily providing liquidity and market depth to the cryptocurrency market while making a profit out of it. Crypto market-makers typically trade on multiple exchanges, and the trading is often automated and connected to exchanges via API. Within the market, quotes are generated by self-owned funds and algorithmic models to attract buyers and sellers to trade. Some crypto market-makers will also offer over-the-counter trading services, supporting block trades and customized trades. Due to the volatility and uncertainty of crypto markets, crypto market-makers need to adjust market strategies in real time, including trade size, quote range and hedging.

The crypto market-making generally consists of the following steps.

(1) Selecting trading pairs: Selecting a group or groups of trading pairs, which is usually subject to market liquidity and the capacity of the market-maker.

(2) Quoting: set bid and ask prices and post them in the exchange’s trading depth tables.

(3) Matching: As soon as a trader is willing to match a market-maker’s quote, the market-maker will immediately match the trade and close it.

(4) Risk control: Risk control is the utmost important step for market-makers. Market-makers adopt various tools and strategies to control risk associate with trading, such as trade limits, stop orders and hedging.

(5) Settlement and Clearing: Once the transactions are completed, the market-maker needs to settle and clear the transaction, including charging fees and paying related taxes to buyers and sellers.

In addition to the above steps, market-makers must constantly monitor market conditions, including market liquidity, actions of competitors, and market risks in order to adjust strategies and quotes in a timely manner.

2.2.1 Market-making Strategy

Market-making strategy is a risk-neutral intraday spread arbitrage strategy, which is one of the quantitative trading strategies in high-frequency trading that follows the principle of “buy low and sell high”. The basic principle is: between the ask and bid price of a certain asset, insert a buy order and a sell order. If the inserted two orders are filled, the market-maker will absorb the spread between the actual price; the whole process is completed, the market-maker’s position does not change. If there is a surplus in the spread between the buy and sell orders after deducting various transaction fees, then the market-maker has earned a corresponding profit. Common market-making strategies include spread strategies, hedging strategies, quantitative trading strategies, etc.

Market-making strategies are divided into spot market-making and futures market-making depending on the type of market. The spot market-making strategy has four modules: short-term trend determination, market-making, rebalancing and main loop. The futures market-making strategy is more complex, it includes complex logic such as timing of market-making, net position handling, locking, moving, and reduction of holdings according to counter-party.

2.2.2 OTC

Crypto market-makers typically provide OTC trading services by establishing contact with counterparties to negotiate prices and trade details with them. Specifically, crypto market-makers post market-making prices on trading platforms or other OTC channels and wait for counterparties to accept and trade. In addition, crypto market-makers can utilize their own liquidity pools to provide real-time quotes and trading opportunities to counterparties when needed to meet liquidity needs. At the same time, crypto market-makers can also provide counterparty clearing and settlement services to ensure smooth trading and capital security.

2.3 Threshold of Technology

Crypto market-makers must be consistent with traditional market-makers in terms of technology, but crypto market-makers need to master additional technologies, namely blockchain. Cryptocurrency trading is based on blockchain, crypto market-makers must understand blockchain technology and its application to cryptocurrency trading in order to understand the nature and technical details of trading. Meanwhile, crypto market-makers must familiarize with how exchanges and wallets interact with the blockchain, and how to identify and resolve issues such as transaction delays due to network congestion or other issues.

Moreover, for the crypto industry, the security of assets cannot be neglected. Since there are certain security risks associated with cryptocurrency transactions, crypto market-makers need to master relevant security technologies to protect the security of the trading system. Specific technologies include multiple signature technology, cold wallet storage, secure communication protocols, transaction monitoring and anti-fraud technology, data backup and recovery technology, etc.

Including but not limited to:

(1) Digital currency exchange API: Crypto market-makers need to master the digital currency exchange API (Application Program Interface) in order to connect with the exchange and access market data, perform trading operations, etc.

(2) Data analysis and machine learning: The cryptocurrency market is highly volatile, so crypto market-makers need to have certain data analytical skills, including analysis of market sentiment and prediction of price movements. Machine learning can help market-makers make more accurate trading decisions.

(3) Social media and online marketing: The cryptocurrency market has demonstrated strong attribute of socialization, crypto market-makers need to have some social media and online marketing skills in order to interact and communicate with potential clients.

2.4 Exchanges and Market-makers

Digital currency exchanges have a subtle relationship with their market-makers. Some crypto exchanges may have their own market-making teams, but there are also many exchanges that choose to partner with third-party market-makers. Exchanges work with market-makers in two forms.

(1) Direct partnership with crypto exchanges

Market-makers work directly with crypto exchanges to provide market-making services for floor trading. Exchanges usually offer some specific market-maker programs that require the cooperation of these teams and provide customized trading interfaces, but these are passive trading interfaces and cannot actively execute orders; it can only be done internally by the exchange in order to implement active management, directly or indirectly embedded in the match-making system of the exchange.

At this point, market-makers need to access information, such as the exchange’s order book and market depth through API, and conduct pricing and match-making by self-owned algorithm and trading strategies.

The exchange needs to provide relevant module interface to the market-maker, which usually includes quote data, order withdrawal, deposit notice, etc.

(2) Indirect partnerships with crypto exchanges

Market-makers cooperate with crypto exchanges through other intermediaries or platforms to provide over-the-counter market-making services. In this case, the market-maker needs to negotiate with the intermediary or platform, determine the cooperation method and details of cooperation, and obtain the market information of the exchange through the API or other channels, and then conduct OTC trading.

It is important to note that market-makers are not necessary for crypto exchanges in terms of liquidity provision; some exchanges may use other methods to improve liquidity, such as depth pools or order book matching engines. When working with a crypto exchange, market-makers need to negotiate with the exchange on the details of the partnership, fee allocation, trading volume, etc., to ensure a smooth and profitable partnership. At the same time, market-makers need to strictly comply with the rules of the exchange and external regulations to ensure legal compliance of transactions.

In the lens of trading mechanism, market-makers that are internally connected with exchanges are largely involved in the price determination process, which can, to a certain extent, inhibit price manipulation, improving expectations of investors and project teams, and stabilizing the market sentiment.

The presence of market-makers contributes to the liquidity of an exchange. The more liquid an exchange is, the better the trading experience for users, the more loyal the users are, and the more profitable the exchange can be. As a result, an exchange is willing to give rebates to market-making activities.

Around 2017 and 2018, a large number of new exchanges were launched with the concept of “trading as mining”, and some of them even offered 120% rebates based on trading volume in the early stages of their operations to attract market-makers to participate in trading.

In order to attract market-makers to trade on exchanges, all major exchanges have launched their own solutions. First, the trading platform itself must possess diversified service offerings, including more spot trading pairs and futures, interest-bearing products (low-interest-rate lending services, etc.), more trading strategies and algorithmic services. Second, a reasonable and attractive commission rate is convincing. Last but not least, the risk control and reputation of the exchange are of utmost importance. Here is a list of some of the activities offered by exchanges for market-makers.

From the list above, Gate has continued to launch market-making campaigns to attract market-making teams since the launch of the Global Market-maker Program in 2021. At the same time, the market-making rates and GT positions are also being adjusted. In addition to that, some services are exclusively available to market-makers, including 0 interest credit lines.

Market-makers participate in the spot, futures, and options markets, and the threshold is getting higher. Accordingly, exchanges grant different privileges in different participating markets. In general, exchanges may grant market-maker privileges in the following items in:

For market-makers, transaction fees are particularly critical, especially for high frequency trading. Admittedly, in the early days of an exchange, it is highly likely that some market-makers will be paid to conduct market-making activities, especially in futures and options.

2.5 Projects and Market-makers

In the crypto market, the liquidity of tokens is as vital as the product, team, and operations. The relationship between project parties and market-makers is mainly established by liquidity provision services of market-makers to project parties. Project parties, especially new projects in the ICO or IEO phase, are in need of price management for tokens by market-makers. Market-makers play 3 rules:

(1) to make up for the lack of market liquidity;

(2) to stabilize the price of tokens and prevent the project from failing when the price is too high or too low;

(3) to improve the market recognition of the project market capitalization management.

These tasks are assigned to a professional market-maker, which incurs less cost than the project team to operate on their own.

Due to the lack of regulation, market-makers can drive volume by buying and selling on the market. Evidently, this “forged” volume can attract the attention of some investors.

Project parties will choose some well-known crypto exchanges to work with market-makers for better liquidity and higher market recognition, which requires the project to provide a certain number of tokens to the market-maker for initial circulation. Market-makers agree to provide active liquidity to the order book for at least 90% of the contract term, in exchange for which they receive 2–5% of the project’s total token supply. For market-makers, working with well-known project parties can increase their visibility and reputation in the market-making sector and help attract more trading pairs. Therefore, the partnership between project parties and market-makers is unparalleled in the crypto market.

In addition to providing liquidity, market-makers provide additional services to project owners, including token pricing (especially STG) strategies and cash-out services.

2.6 Profit Model of Crypto Market-makers

Like traditional market-makers, crypto market-makers make their profits from the spreads of trading actions. However, in the absence of regulation in the crypto market, such spreads can be large; with high market volatility, the returns may also be uncertain.

There are two other sources of revenue for crypto market-makers:

(1) market-making for project parties; and

(2) assisting exchanges in sustaining sufficient liquidity and trading volume.

A market-maker can profit from the following two modes when partnered with project parties:

There are also two profit models for working with exchanges:

As the number of market-makers increases, it has become more competitive; market-makers will narrow their quoted spreads in order to win over more markets, resulting in less revenue.

2.7 Criteria of Market-maker Evaluation

For market participants, it is vital to have the ability in evaluating the performance of market-makers and choose the right market-maker. Common metrics used to evaluate market-makers include market-maker’s trading volume and frequency, accuracy and stability of quotes, profitability and risk management capabilities, market share and reputation. Nevertheless, for exchanges, market takers and project parties, the performance of liquidity provision is valued the most. The performance can be evaluated by measuring depth of quotes, accuracy, frequency of updates, and efficiency of transactions.

Simple indicators are listed in each exchange’s market-maker activity, including market-maker volume of commission, bid/ask spreads, quotes, requested coverage, market-making duration, etc. However, some exchanges may use complicated indices, such as weighted depth multipliers and liquidity index.

3. Risk analysis and management of crypto market-makers

3.1 Regulation and Compliance

Crypto market-makers are still in a grey area, and they are not yet legalized by clear law and regulatory framework in most countries and regions. By all means, crypto market-makers are generally not subject to the strict regulatory standards set forth in traditional financial markets, nor are they regulated by the appropriate regulatory bodies. However, in some countries and regions, regulators have begun to explore ways to regulate crypto market-makers to ensure transparency, fairness and stability in the market.

The regulatory bodies that oversee crypto market-makers include the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in the U.S., which have certain regulatory responsibilities for crypto markets, with the SEC regulating the securities nature of crypto assets and the CFTC regulating transactions such as crypto derivatives contracts. In addition, ESMA, the regulator of EU financial markets, has also begun to explore a regulatory framework for crypto markets, aiming to ensure transparency and stability in crypto markets.

In recent years, several cases have been made by the above regulators:

(1) The U.S. Securities and Exchange Commission (SEC) announced in July 2020 that Coinbase and other crypto exchanges can register as brokerage firms and exchanges, and offer market-making services for digital assets on their trading platforms. It indicates the SEC has begun to explore the regulation of crypto market-makers.

(2) The Swiss Financial Market Supervisory Authority (FINMA) released a guide on cryptocurrency regulation in 2019, which mentions the compliance requirements for traders and market-makers, as well as what licenses are to be obtained in order to conduct such activities. This indicates that FINMA has started regulating crypto market-makers.

(3) The Singapore Stock Exchange (SGX) launched its digital currency trading platform SGX iSTOX in 2020 and developed a regulatory framework with market-makers to ensure their compliance and transparency. This indicates that SGX has begun to explore the regulation of crypto market-makers and has started to work with them.

From the above cases, it is evident that regulators have begun exploring on regulations of crypto market-makers and have developed some relevant guidelines and regulatory frameworks. In the future, as the crypto market continues to grow, regulations on market-makers will become a critical part in the industry.

In terms of compliance requirements, crypto market-makers are also subject to various regulations, which vary from country to country, but some common compliance requirements include:

(1) KYC (Know Your Customer): Market-makers need to comply with KYC regulations and ensure that identities of clients are verified and recorded.

(2) AML (Anti-Money Laundering): Market-makers are required to comply with AML regulations to prevent cryptocurrencies from being used for money laundering and other illegal activities.

(3) Data protection: Market-makers are required to comply with data protection regulations to protect the security and privacy of client data.

(4) Trading transparency: Market-makers need to provide trading transparency, including publicly available trading data, market depth and other information to ensure fair and transparent trading.

In addition, some countries or regions may have other regulatory requirements, such as regulations in areas such as taxation, securities or futures.

3.2 Market Risk

Market-makers are exposed to multiple risks in the crypto market, including:

(1) Price Risk: Due to the highly volatile nature of the cryptocurrency market, market-makers are exposed to price risk, meaning that cryptocurrencies held by market-makers may experience losses in the event of significant market price fluctuations.

(2) Liquidity risk: Market-makers need to provide liquidity to support trading in the market, but if there is selling or buying pressure in the market, it may be difficult for market-makers to provide sufficient liquidity in a timely manner, resulting in situations such as delayed or failed trades.

(3) Counterparty risk: Due to the anonymity and decentralized nature of the cryptocurrency market, market-makers may not be able to determine the creditworthiness and trading intentions of their counterparties, and are thus exposed to counterparty risk, i.e., market-makers are unable to fulfill orders from counterparties.

(4) Funds risk: Similar to traditional market-making, in plain words, the size of the market-making capital and the turnover of funds determines the hierarchy of market-makers. Especially when it comes to deposit and withdrawal of funds, which may become the first threshold for market-making. Market-making teams generally bank with Silvergate bank and Signature bank. But the two crypto-friendly banks recently faced bankruptcy, with many funds unable to be withdrawn. This raises the bar for future institutions to enter the crypto industry.

To cope with the above risks, every market-maker has certain strategies, such as retreat in extremely volatile markets, or hedging to preserve value on current positions, transferring risk to assets based on inventory model and information model.

3.3 On-chain and Off-chain Risks

Off-chain risks are generally trading risks, such as historical data integrity, flaws in strategy model design, system failures, lack of risk control, overfitting, and transaction cost-sensitive risks.

(1) Pricing risk: It determines whether the market-maker can offer an attractive price; whether the pricing is rational or not is directly related to a market-maker’s win/loss.

(2) Inventory risk with large fluctuations in asset prices: If the price of the underlying asset moves in a unilateral direction, for example, in an uptrend, a sell order is filled but a buy order is not filled, a market-maker will bear the risk of increase in selling price (sold cheap). In a downtrend, a buy order may be filled but a sell order is not, then a market-maker is exposed to the risk that the buying price may be cheap later (bought expensive).

(3) Trading platform risks:

(4) API risk: Including internal divulge, API breakdown, etc.

The source of risks in the crypto market is not only the risk from off-chain trading behavior, but more come from on-chain. First, if the smart contracts for market-making tokens are vulnerable and hacked, this could result in the loss of the market-maker’s inventory of assets. Secondly, crypto market-makers may need to participate in on-chain protocols or DeFi applications to provide liquidity, and all risks on-chain will be transmitted to each participant. For example, a fork in an L1 chain where the protocol is located or low speed for on-chain transactions.

3.4 Risk Management

In order to control the above risks, a market-maker should enforce strict strategies and disciplines.

(1) Focus on deal quality rather than quantity

While market-makers can earn a certain amount of commission by providing liquidity to the exchange, overtrading tends to waste more time and money; the key to effective trading is to focus on the quality of trades rather than the quantity of trades.

This is reflected in three aspects:

(2) Establishing partnerships

Market-makers need to establish good relationships with exchanges, project parties, investors, etc. to get more information and support and reduce their own risks.

(3) Strict discipline

This includes exit condition and not abusing leverage. Market-makers must control risk exposure and diversify as much as possible.

(4) Inventory Risk Management

In general, inventory volume and inventory risk are positively correlated in the market-maker system. A large amount of inventory is risky, and the correlation between the amount of inventory and price changes is the greatest; when there is an expectation of price increases, the amount of inventory increases, and vice versa.

However, when the price is at a high level, the amount of inventory is in need to be reduced, otherwise, the inventory purchased at high prices will tend to depreciate in value if the market price decreases, and the inventory risk is greater. Therefore, in order to reduce this risk, market-makers will tend to reduce their inventory on cryptocurrencies with higher appreciation. In this case, inventory volume is negatively correlated with price. In addition, the amount of inventory is positively related to the market-maker’s own capital.

(5) Monitoring the Market

Market-makers need to constantly monitor changes in market liquidity, including market depth, volume, trading pairs and other indicators, and adjust quoting strategies in a timely manner to ensure that there is sufficient liquidity to be injected to the market.

4. Typical case study of crypto market-maker

In recent years, crypto market-making firms have been on the rise as the cryptocurrency market continues to grow. These firms are dedicated to providing liquidity management, price discovery and brokerage services to meet the growing demand for cryptocurrency trading. Currently, there are many global professional crypto market-maker companies, which adopt various technologies and strategies to provide diverse trading services to market participants, contributing to the further development and maturity of the cryptocurrency market. Since the crypto market is still far from traditional finance, there is relatively less effort for market-makers to achieve monopoly, and the liquidity of cryptocurrencies is dominated by a few large market-makers, which includes Jump, Wintermute, Amber Group, B2C2, and DRW Trading.

4.1 The FTX Incident and Alameda Research

Alameda Research was founded in 2018 in California, USA. The company was founded by mathematician, Samuel Bankman-Fried, who worked at Jane Street, where he gained extensive experience in quantitative trading. In addition to market-making and quantitative trading in the crypto market, the company has developed several cryptocurrency trading tools and infrastructure, such as the crypto exchange FTX and Serum, a crypto trading protocol on Solana.

The FTX crash was followed by the bankruptcy of Alameda Research, and the market-making team at FTX suffered significant losses, as seen in Kaiko’s data on BTC pending orders after the FTX event, indicating a lack of liquidity. The digital assets suffered from the collapse of FTX and Alameda include FTT and SOL; these tokens led to a crunch of liquidity on Solana and liquidation risk for all tokens.

4.2 Wintermute and DeFi Hacking Incidents

Wintermute Trading is a cryptocurrency market-maker based in London. The company was founded in 2017 by Evgeny Gaevoy and Harro Mantel. Wintermute Trading’s main business is to provide liquidity services to cryptocurrency exchanges, institutions and individuals, as well as market-making services in a number of cryptocurrency derivatives markets. At this stage, Wintermute has partnerships with over 50 cryptocurrency exchanges. It is in a leading position in terms of trading volume on all exchanges. Core team members include:

In addition to its business in the cryptocurrency market, Wintermute Trading is actively involved in promoting the development and standardization of the cryptocurrency market. The company is a member of the London Digital Asset Trading Association (LSTA) and a member of the Association of Digital Asset Dealers (ADAM). In February 2021, Wintermute announced the closing of a $25 million funding round with investors, including Lightspeed Venture Partners and Pantera Capital. However, due to the bear market and hacking, Wintermute’s revenue in 2022 was around $300 million, far below the $1 billion in 2021.

In September 2022, Wintermute lost $160 million when its EOA wallet was stolen due to the possible use of the Profanity tool to create customized wallet.

4.5 GSR Market

GSR Markets is genetically an algorithmic digital trading company in Hong Kong. It provides liquidity by utilizing its own software on order execution solutions for several digital asset classes. The company deploys multiple trading models that integrate more than 30 liquidity pools, and its trading fees are relatively low in the market.

Features:

Recently, GSR has been working frequently with various project parties, including Stargate, which will provide GSR with 8 million STG European-style options on the condition that the average STG price exceeds $1.15 in 24 months. After the proposal is passed, STG surged 36.2% in the last 14 days.

5. Decentralized Market-makers

Anyone participating in on-chain market-making behavior is a decentralized market-maker, mainly in three forms: (1) participation in the liquidity provision of decentralized exchange DEX, also known as mining behavior, which has a low threshold that anyone can participate, providing liquidity for trading pairs and receiving certain rewards; (2) participation in the decentralized derivatives market, similar to dydx; (3) some DeFi specialized services for market-making protocols, such as Elixir, which becomes liquidity distribution tools for the CLOB and AMM models.

The automated market-maker algorithm AMM is generally deployed inside DEX, where anyone can become a market-maker. It adopts an automated algorithm to balance the supply and demand for tokens in a trading pool. AMM functions by allowing liquidity providers to deposit tokens (usually in equal amounts) into the liquidity pool. The price of the tokens in the liquidity pool then follows a formula such as the constant market-maker algorithm x*y = k, where x and y are the number of tokens in the pool for both tokens and k is a constant. This results in the ratio of tokens in the pool becoming the determinant of the price, ensuring that the pool always provides liquidity regardless of the transaction size, and the amount of slippage is determined by the transaction size compared to the pool size. As the price in the liquidity pool deviates from the global market price, arbitrageurs will enter and push the price back to the global market price. Various protocols iterate on this basic AMM model or introduce new models such as Curve, Balancer, and Uniswap V3 to offer upgraded performance and extend it to derivatives.

Risk also exists in DeFi; LPs bear the risk of original bugs of smart contract, draining pool and default. The DEFI protocol offers different market-making strategies and liquidity pools to lure LPs and professional market-making teams along with higher yields. Even so, each of on-chain market-making and market-making in centralized exchanges has its own merits, and they cannot replace each other.

Another thing to mention is the specialized market-making protocol, represented by Elixir, which has two types of users: (1) project parties and (2) users who desire to become market-makers. The specific mechanism is as follows:

So far, centralized market-makers cannot cooperate with project parties in an open and transparent manner, provided that the commission is high. However, through on-chain market-making protocols can it effectively improve the utilization of users’ funds and become liquidity providers; through suitable algorithms and strategies, liquidity problems can be solved for project parties, and users could benefit at the same time. However, the mechanism of on-chain market-making protocol is intricate and less flexible, which may be difficult to cope with market risks.

6. Opportunities and challenges for crypto market-makers (with a list of financing history)

The rapid growth of the cryptocurrency market has led to an increasing demand for cryptocurrency market-makers, and also given rise to more innovative technologies and business models. The future trends of crypto market-makers are reflected in the following areas:

Cryptocurrency markets demonstrate many unique characteristics, and face various challenges in liquidity. For example, crypto markets are open 24/7/365; retail investors could do self-custody and directly interact with exchanges (exchanges play the role of broker, exchange and custodian); instant settlement of virtual balances could be done at CEX; fast settlement of on-chain transactions at DEX can be achieved compared to T+2 in traditional financial settlement; stablecoins are in place to facilitate transactions with consideration of the volatility of BTC and still-cumbersome conversion of fiat to crypto. In addition, crypto markets remain highly unregulated, leaving loop holes for price manipulation; the market continues to be highly fragmented with liquidity diverging on-chain and off-chain. Besides, trading technology continues to evolve as the quality of API connectivity on exchanges varies and declines cyclically when the market is active. Finally, the crypto derivatives market is still growing, as derivatives are much smaller relative to spot compared to traditional financial markets. These characteristics pose challenges in providing liquidity, including market fragmentation/interoperability, capital inefficiencies, regulatory uncertainty, and exchange technology/connectivity that is still undeveloped.

In conclusion, as the cryptocurrency market continues the changes, market-makers need to continuously adjust strategies and business models to better adapt to the changes and demand of the market. At the same time, market-makers also need to strengthen cooperation and communication with other market participants in order to jointly promote the development and growth of the market.

7. Summary and Thoughts

Whether in the traditional industry or in the crypto market, market-makers must always immerse in the market in order to trade with “spreads” on hand, and different markets usually hint more profit opportunities. In the future, crypto market-makers will look more alike market-makers in traditional finance:

(1) More diversified. Comprehensive large investment banks and electronic trading platforms and other institutions may join;

(2) More varieties. Various types of spot and derivatives will be the target of market-making, and more varieties as the market grows;

(3) High leverage. Market-making business represented by spot and derivatives trading is a typical capital-intensive business, and investment banks mostly utilize leveraged funds to expand business scale; the leverage of market-making business is often higher than other businesses. Other crypto lending businesses will be hatched based on this, and the risk level of the whole industry is elevated.

(4) The 80–20 rule will be more prominent. Top-tier players usually have sufficient talent pool, strong capital strength, rich client resources, excellent pricing ability and large asset size. Large institutions could reduce risk and cost by diversification and hedging, which endows the institutions with more advantages in market-making business.

Although the size of crypto market-makers is expanding and the competition is getting fierce, in fact, crypto market-makers have relatively high technical barriers with higher risks. For example, in the FTX incident, Cumberland, GSR, Wintermute, Jump, folkvang and Nibbio all have open positions in FTX as market-makers. At the same time, the recent news on Silvergate Bank also pose unknow threat to all the market-makers. In all, the capital turnover means everything for a market-maker.

Traders must identify if a market-maker is colluding with a project so that the right price trend can be distinguished. Clues can be found from token price and trading volume.

Decentralized market-maker protocols, including DEX and others, are also competing on some market-making teams to participate on-chain market-making. In my humble opinion, order book could satisfy the diverse trading strategies of market-making teams, while AMM has certain limitations and low ability in control. Market-making teams will participate in on-chain market-making if the opportunity is considerably lucrative, yet it is not commensurate with the status of exchanges in the crypto world. Meanwhile, the impact of some innovative DeFi protocols cannot be ignored. It is worth noting that some market-makers have started to explore market-making in the NFT market, and more explorations will be seen on on-chain products and those derivatives with available secondary market.

However, a pitfall cannot be ruled out here. Similar to Alameda, large market-makers may incubate their own on-chain protocols, either DEX or lending protocols, such as DEX Bebop incubated by Wintermute. The large amount of capital can be a boost to the protocol per se, but it also poses a risk to the market as a whole.

7.1 Thoughts on Direction of Investment

Market-makers play a significant role in the trading segment, and their profitability are potential in both bull and bear cycles. In the market-making sector, the following investment directions are worth some attention:

References

[1] “High-Frequency Trading and Market-making in the Bitcoin Ecosystem”, from the European Central Bank, analyzes high-frequency trading and market-making in the Bitcoin ecosystem.

[2] “The Market Microstructure of Currency Markets,” from the European Central Bank, analyzes the market microstructure and the role of market-makers in currency markets.

[3] “Market-making in the Corporate Bond Market,” from FINRA, explores market-makers in the corporate bond market.

[4] “How to Be a Market-maker,” from the Harvard Business Review, describes the fundamentals and strategies of market-making.

[5] “Market-making and Revenues of Stock Exchanges: A Survey of the Literature,” from the European Securities Market Supervisory Authority, provides an overview of the impact of market-makers on stock exchange revenues.

[6] “Market-making with Costly Monitoring: An Analysis of the SOES Controversy,” from the National Bureau of Economic Research, analyzes the market-maker strategy in the NASDAQ exchange SOES system controversy.

[7] Thinking about the Future of Market-makers, GSR, 2021.

[8] Digital Currency Market-makers Research Report, TokenClub, 2018.09

[9] Talking about cryptocurrency (digital currency) market-makers

[10] Why your ICO needs a market-maker. Evgeny Gaevoy (CEO at Wintermute) .

[11] Getting rid of market-makers: How to create on-chain liquidity?

[12] Pantera Partners: Read about cryptocurrency market-maker Wintermute

[13] The development path and experience of market-making business in the United States, Ping An Securities, 2022.08

Read more: https://huobiresearch.medium.com/market-makers-the-recluses-through-cycles-96dfab8aa6fc