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How market makers provide liquidity and stabilize crypto markets | Image by Tyler Prahm
Market makers are essential players in financial markets, particularly in the volatile world of cryptocurrencies. They are individual users or institutions that provide liquidity on a cryptocurrency exchange or platform, ensuring that other market participants can always find liquidity – meaning they can buy or sell without significant delays or price slippage.
This role is crucial across both traditional finance and the crypto markets, as liquidity – the ease of trading an asset – underpins price stability and market confidence. High liquidity generally signals a stable market with minimal volatility, whereas low liquidity often leads to sharp price swings and higher transaction costs.
This article breaks down how market makers provide liquidity and stabilize crypto markets.
What is market making in crypto?
Market making is the practice of providing liquidity by simultaneously placing buy and sell orders for a crypto asset or any other asset class. The bid-ask spread is a key concept: it’s the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) at a given moment.
This spread represents the transaction cost for immediate trades and is also the source of profit for market makers. A market maker quotes both a bid price and an ask price, and if another trader buys from the market maker’s ask or sells into their bid, the market maker earns the spread (minus any fees). For example, if a market maker is bidding $100.00 and offering $100.10 for a crypto token or digital asset, the $0.10 difference is the potential profit per unit for the market maker.By continuously updating these quotes, market makers facilitate trading by ensuring there’s always someone willing to transact at near the current market price.
Beyond profiting from spreads, market makers serve a broader purpose: facilitating price discovery and trade execution. In an order-driven market without a market maker, a trader who wants to buy might have to wait for another participant to independently decide to sell at the same price (and vice versa). This can be slow and inefficient, especially in less active markets. Market makers solve this by always being available to take the other side of a trade.
As market makers adjust their prices in response to order flow and news, they help the market reach a consensus on value – a process known as price discovery.
Crucially, market making greatly reduces transaction costs for other traders. A narrow bid-ask spread means that traders can enter or exit positions without paying a large premium or discount. In a liquid market with active market makers, the spread might be just a few basis points (a tiny fraction) of the asset’s price, whereas in an illiquid market, the spread could be substantial (several percent or more). By narrowing spreads and providing depth, market makers make trading more cost-effective and efficient for everyone.
In summary, market making is all about providing liquidity: market makers continuously post bids and asks, maintain inventory in the asset, and earn the bid-ask spread as compensation for the risks they take in keeping the market liquid.
The role of market makers in providing liquidity
Market makers are fundamentally crypto liquidity providers. They populate the order book with buy and sell orders at various price levels, creating depth that allows large orders to be executed with minimal price impact.
In practical terms, a market maker will maintain an inventory of the asset and continually adjust their bids and asks. If there’s a surge of buying demand, the market maker’s inventory will decrease as they sell to buyers – but they will also likely raise their prices (both bid and ask) as their inventory gets depleted and demand pushes the price up. Conversely, if there’s a wave of selling, the market maker will buy from sellers (increasing inventory) but will lower their quoted prices in response.
By dynamically updating quotes based on real-time market conditions, market makers smooth out temporary supply/demand imbalances. This practice prevents extreme price discrepancies and keeps trading flowing in an orderly fashion.
One important result of this added liquidity in crypto markets is a tighter bid-ask spread. With many buy orders just below the current price and sell orders just above, the gap between the best bid and best ask narrows. A deep order book with lots of liquidity at each price level tends to keep spreads very tight.Market makers actively manage this by competing with each other – if one market maker sets a slightly narrower spread, others often follow suit to stay competitive, which benefits traders with better prices. For instance, an inefficient market might have a 6% bid-ask spread due to lack of liquidity, but active market makers can tighten that spread to, say, 0.2%.
This improvement reduces trading costs and enhances price stability by optimizing order book depth and spreads, creating a more efficient market.
Additionally, market makers play a role in preventing large price swings. In times of sudden market stress or surging demand/supply, a normal order book might thin out – meaning there aren’t enough standing orders to absorb the shock. Market makers step in as contrarian liquidity providers: when sell-offs accelerate, they buy to slow the decline; when buying surges, they sell to temper the spike, acting as buffers against volatility.
During extreme volatility, they may widen spreads to manage risk but still provide liquidity when others withdraw. This continuous presence helps prevent severe crashes and dampens short-term price swings.
Market makers are incentivized to do this because they ideally want to “buy low and sell high” around the current fair value; if prices overshoot in either direction, the market maker’s strategy is to provide liquidity that nudges prices back toward equilibrium. This continuous presence helps prevent severe crashes and dampens short-term price swings.
Market makers and market stability
Liquidity and stability go hand in hand, especially in crypto trading environments. A market with abundant liquidity is much more resistant to wild price swings. This is because when buy and sell orders are plentiful at many price levels, any incoming market order (an order that seeks immediate execution) will “walk” through the order book gradually – matching with available liquidity – rather than drastically moving the price. Market makers, by providing that base of orders, directly contribute to price stability. In a highly liquid market, prices tend to move in smaller increments and with more continuity. Conversely, in an illiquid market, a large market order can suddenly gap the price up or down because there were not enough resting orders to fulfill it near the last traded price.
By ensuring liquidity, market makers buffer the market against these abrupt moves. In fact, regulators and market operators often view the presence of active market makers as a sign of a healthy market, because their liquidity provision makes prices less susceptible to manipulation and shocks.
In practical terms, liquidity buffers price volatility by absorbing imbalances. If a sudden wave of selling hits a liquid market, the presence of many buy orders (from market makers or otherwise) means the price might only drop a small percentage before finding buyers and stabilizing. In an illiquid scenario, that same wave of selling could free-fall the price dramatically. This is why we often see that major stock indices or large-cap crypto assets(which are very liquid) have lower volatility in percentage terms compared to smaller, traded assets. Market makers contribute to this effect by ensuring that even when natural buyers or sellers are scarce, they are there to take the other side, preventing prices from spiraling. A classic example is during flash crashes or sudden panic events: markets that retain liquidity providers recover faster and have shallower drops.
Preventing flash crashes and extreme volatility is a key benefit of strong market-making. A flash crash refers to an extremely rapid price plunge (and often recovery) within minutes or seconds. These events are often exacerbated by a lack of liquidity – when many sellers hit the market at once, and buyers pull back, the price can nosedive until buy orders reappear. Market makers can mitigate such events by continuing to provide bids when others won’t.
Conclusion
Market makers are vital for a healthy and efficient crypto ecosystem. By providing liquidity, they:
- Ensure continuous trading with minimal friction.
- Reduce bid-ask spreads, lowering transaction costs.
- Stabilize prices by absorbing market imbalances.
- Prevent flash crashes and extreme volatility.
As the crypto industry grows and integrates with traditional finance, market making is evolving but remains at the heart of market dynamics. Projects that prioritize liquidity and partner with or create effective market-making solutions set themselves up for smoother trading experiences and greater long-term success.
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The full breakdown
In our first article, "Navigating Crypto Volatility: The Advantages of Active Management," we explored how the high volatility and low correlation of digital assets with traditional asset classes create unique opportunities for active managers. We discussed how these characteristics enable active managers to execute tactical trading strategies, capitalizing on short-term price movements and market inefficiencies. Building on that foundation, we now turn our attention to the unique market microstructure of digital assets.
Conducive market microstructure of digital assets
The market microstructure of digital assets - a framework that defines how crypto trades are conducted, including order execution, price formation, and market interactions - sets the stage for active management to thrive. This unique ecosystem, characterized by its continuous trading hours, diverse trading venues, and substantial market liquidity, offers several advantages for active management, providing a fertile ground for sophisticated investment strategies.
24/7/365 market access
One of the defining characteristics of digital asset markets is their continuous, round-the-clock operation.
Unlike traditional financial markets that operate within specific hours, cryptocurrency markets are open 24 hours a day, seven days a week, all year round. This continuous trading capability is particularly advantageous for active managers for several reasons:
- Immediate response to market events: Unlike traditional markets that close after regular trading hours, digital asset markets allow managers to react immediately to breaking news or events that could impact asset prices. For instance, if a significant economic policy change occurs over the weekend, managers can adjust their positions in real-time without waiting for markets to open.
- Managing volatility: Continuous trading provides more opportunities to capitalize on price movements and volatility. Active managers can take advantage of this by implementing strategies such as short-term trading or hedging to mitigate risks and lock in gains whenever market conditions change. For instance, if there’s a sudden drop in the price of Bitcoin, managers can quickly sell their holdings to minimize losses or buy in to capitalize on the lower prices.
Variety of trading venues
The proliferation and variety of trading venues is another crucial element of the digital asset market structure. The extensive landscape of over 200 centralized exchanges (CEX) and more than 500 decentralized exchanges (DEX) offers a wide array of platforms for cryptocurrency trading. This diversity is beneficial for active managers in several ways:
- Risk management and diversification: By spreading trades across various exchanges, active managers can mitigate counterparty risk associated with any single platform. Additionally, the ability to trade on both CEX and DEX platforms allows managers to diversify their strategies, incorporating different levels of decentralization, regulatory environments, and security features.
- Arbitrage opportunities: Different venues often exhibit price discrepancies, presenting arbitrage opportunities. For example, managers can buy an asset on one exchange at a lower price and sell it on another where the price is higher, thus generating risk-free profits.
- Access to diverse liquidity pools: Multiple trading venues provide access to diverse liquidity pools, ensuring that managers can execute large trades without significantly impacting the market price.
Spot and derivatives markets (Variety of instruments)
The seamless integration of spot and derivatives markets within the digital asset space presents a considerable advantage for active managers. With substantial liquidity in both markets, they can implement sophisticated trading strategies and manage risk more effectively.
For instance, as of August 8 2024, Bitcoin (BTC) boasts a daily spot trading volume of $40.44 billion and an open interest in futures of $27.75 billion. Additionally, derivatives such as futures, options, and perpetual contracts enable managers to hedge positions, leverage trades, and employ complex strategies that can amplify returns.
Overall, the benefits for active managers include:
- Hedging and risk management: Derivatives offer a powerful tool for hedging against unfavorable price movements, enabling more efficient risk management. For instance, a manager holding a substantial amount of Bitcoin in the spot market can use Bitcoin futures contracts to safeguard against potential price drops, thereby enhancing risk control.
- Access to leverage: Managers can use derivatives to leverage their positions, amplifying potential returns while maintaining control over risk exposure. For instance, by employing options, a manager can gain exposure to an underlying asset with only a fraction of the capital needed for a direct spot purchase, thereby enabling more capital-efficient investment strategies.
- Strategic flexibility: By integrating spot and derivatives markets, managers can implement sophisticated strategies designed to capitalize on diverse market conditions. For instance, they may engage in volatility selling, where options are sold to generate income from market volatility, regardless of price direction. Additionally, managers can leverage favorable funding rates in perpetual futures markets to enhance yield generation. Basis trading, another strategy, involves taking offsetting positions in spot and futures markets to profit from price differentials, enabling returns that are independent of market movements.
Exploiting market inefficiencies
Digital asset markets, being relatively nascent, are less efficient compared to traditional financial markets. These inefficiencies arise from various factors, including regulatory differences, market segmentation, and varying levels of market maturity. For example:
- Pricing anomalies: Phenomena like the "Kimchi premium," where cryptocurrency prices in South Korea trade at a premium compared to other markets, create arbitrage opportunities. Managers can exploit these by buying assets in one market and selling them in another at a higher price.
- Exploiting mispricings: Active managers can identify and capitalize on mispricings caused by market inefficiencies, using strategies such as statistical arbitrage and mean reversion.
The unique aspects of the digital asset market structure create an exceptionally conducive environment for active management. Continuous trading hours and diverse venues provide the flexibility to react quickly to market changes, ensuring timely execution of trades. The availability of both spot and derivatives markets supports a wide range of sophisticated trading strategies, from hedging to leveraging positions. Market inefficiencies and pricing anomalies offer numerous opportunities for generating alpha, making active management particularly effective in the digital asset space. Furthermore, the ability to hedge and manage risk through derivatives, along with exploiting uncorrelated performance, enhances portfolio resilience and stability.
In our next article, we'll delve into the various techniques active managers employ in the digital asset markets, showcasing real-world use cases.
