In this week’s Chart of the Week, we go through the fundamentals of market making, liquidity provisioning on centralized and decentralized exchanges, and speculate on what market making could look like in the future.
Basics of Market Making
On an exchange, market making is the process of issuing two-sided quotations for an asset in the form of bids and requests together with the quote sizes. Doing this gives buyers and sellers more liquidity in situations where there could otherwise have been lower pricing and less market depth.
Theoretically, market makers receive the bid-ask spread in exchange for taking on price risk, such as buying an item for $100 and selling it for $101. However, in reality, crypto assets are unstable, and there is frequently little two-sided flow, making it challenging to capture the bid-ask spread. To generate fees while minimizing risk, market makers often aim to achieve KPIs related to the bid-ask spread, the percentage of time the market maker is the best bid and best offer (known as the top of book), and uptime.
Market makers display two-sided quotations to the market using proprietary software, sometimes known as an engine or bot, continually revising bids and requests up and down based on changes in the market price.
The quality of market-making services varies significantly between market makers, with critical differentiators including technology and software, liquidity provided and adherence to KPIs, transparency and reporting, history and experience, exchange integrations, reputation and support of fair markets, liquidity provisioning across both centralized and decentralized venues, and value-added services like OTC trading, treasury services, industry network and strategic investment.
Larger liquidity and market depth, less price volatility, enhanced price discovery, and drastically reduced slippage are just a few of the many advantages of market creation. But perhaps more crucially, since tokens enable the protocols to function, market-making is essential to the technology.
CEXs vs. DEXs
Professional businesses’ market-making historically occurs on centralized exchanges, which is now more frequently done on decentralized exchanges. The distinctions are:
Centralized exchanges, like Binance and Coinbase, are platforms that act as middlemen between buyers and sellers. A centralized exchange for assets has a bid price, the highest price anybody is willing to pay for an asset, and an ask price, the lowest price anyone is ready to sell an item for. The spread is the difference between the ask price and the bid price.
The two primary categories of orders are maker orders and taker orders. Maker orders are those in which the buyer or seller specifies a price range within which they are willing to purchase or sell. Contrarily, taker orders are instantly carried out at the best price or offer. Many exchanges charge a reduced cost or sometimes none for maker orders since they bring liquidity to the market, whereas taker orders drain it.
An exchange’s central limit order book includes offers and counteroffers and matches customer orders based on price-time priority. Taker orders are carried out at the lowest and highest bid prices.
Exchanges That Are Not Centralized
Some market makers are beginning to provide their services in venues that are not centralized. Due to the cost and speed restrictions of numerous layer ones, central limit order books used at centralized exchanges may be challenging to deploy on a decentralized exchange, given the millions of daily orders by market makers. As a result, many decentralized exchanges employ an automated market maker. This deterministic pricing algorithm uses collections of tokens locked in smart contracts known as liquidity pools.
AMMs enable liquidity providers to deposit tokens into a liquidity pool, typically in equal quantities. Following a formula, such as the constant product market maker algorithm, where x and y are the quantities of the two tokens in the pool and k is a constant, the price of the tokens in the liquidity pool will then be determined.
As layer two solutions advance, several DEXs provide an AMM and a CLOB or follow a more conventional central limit order book approach. A liquidity pool’s liquidity providers get trading fees based on the amount of liquidity they contribute to the pool. Additionally, protocols frequently reward liquidity providers with protocol tokens in a process known as “liquidity mining,” which encourages the delivery of liquidity.
The cryptocurrency market has numerous distinctive features that make it challenging to provide liquidity in some situations. For instance, compared to T+2 traditional finance settlement, crypto markets offer instant “settlement” of virtual balances at CEXs and fast settlement of on-chain trades at DEXs, and facilitate trading using stablecoins, given BTC fluctuation and fiat to crypto conversion which is still clunky.
Retailers can also interact directly with the exchange (exchanges serve as brokers, exchanges, and custodians). Additionally, the crypto markets continue to be highly fragmented, with liquidity split across several on and off-chain venues. They remain primarily unregulated, raising the possibility of price manipulation.
The Future of Market Making
Cryptocurrency is still developing quickly, and market-making for cryptocurrencies is no exception. The following tendencies both exist now and may develop in the future:
The cryptocurrency market is institutionalizing every day. As institutional demand rises, liquidity providers’ significance will only expand.
As cross-chain bridging solutions advance and composability gains prominence, interoperability should improve overall, especially in DeFi. Although this is completely abstracted away from the consumer, including liquidity providers, we envisage a multi-chain world. An alternative to the present system’s costs, settlement delays, and liquidity mining battles is layer two middleware providers, which may communicate with multiple chains in a trustworthy manner to determine the most effective trading paths across several liquidity sources.
Due to fragmented markets and the impossibility of cross-margining, liquidity providers on a centralized exchange must entirely finance their order books at each exchange. Future improvements in capital efficiency might come from more credit extension through crypto prime brokerages or a more regulated repo market.
Because derivatives are so common in conventional financial markets, DeFi derivatives market making and volumes are projected to increase more quickly than spot DeFi volumes.
DeFi protocols frequently reward liquidity provisioning through liquidity mining. Users get their native token for contributing assets to its liquidity pools. However, such liquidity is often transient and disappears as the incentives for mining liquidity do.
Numerous new initiatives known as DeFi 2.0, like OlympusDAO, are experimenting with protocol-controlled liquidity. The initiatives raise money to sustain their protocols instead of using users’ money by rewarding them for mining liquidity. Liquidity provisioning in DeFi may transition from user-contributed to protocol-controlled thanks to these novel approaches.
DeFi vs CeFi
DeFi is likely to grow more quickly than CeFi due to faster innovation from being earlier in its life cycle, given system capital requirements and liquidity mining incentives, larger returns are produced, along with improvements to its present restrictions like decreased gas prices, MEV resistance, more excellent insurance options, and its numerous advantages such as permissionlessness, openness, financial inclusion, immutable recordkeeping, self-custody, and provenance, among others. The more centralized elements of DeFi may be attacked by regulators, which may delay the adoption of DeFi, or more rational guardrails may be put in place, promoting greater institutional engagement, which would likely boost expansion.
CeFi and DeFi’s boundaries are anticipated to converge, notably in liquidity provisioning. The finest liquidity providers don’t care if price discovery occurs on-chain or off-chain. Some market makers offer liquidity across centralized and decentralized domains. While some exchange protocols, like Unizen, are already incorporating quotations from centralized and decentralized venues, others, like Qredo, offer a family of services to include institutions in the mix, including cutting-edge compliance solutions.