Original article: "Demystifying Market Makers"
Author: Yaoyao
FTX collapsed, its empire collapsed, and a series of leading platforms suffered heavy losses, with market makers and lending becoming the hardest hit areas: Alameda, one of the largest market makers in the cryptocurrency industry, was destroyed in this farce and officially ended trading on November 10; Genesis, a market maker and lending company under DCG, is also facing the dilemma of insufficient solvency.
The top market makers collapsed, a large amount of capital was destroyed, and the market trend changed dramatically... This caused unprecedented panic among the market makers in the industry. In the aftershocks, market makers tended to shut down, the community and projects faced huge stress tests, and the market liquidity of the crypto industry experienced a sharp decline.
Whether in the traditional market or the crypto market, for the general public investors, talking about market makers is always like playing a game of blind men and an elephant.
Now let’s start from the beginning and demystify market makers.
Table of contents
01. Market Makers in Crypto
What is a market maker, how to make a market, how to make a profit Market makers in the crypto market What are market makers used for Market making strategies Opportunities, risks and the wild west
02.Yes or No: Everyone is a market maker
Market Makers and Automated Market Makers AMM: Everyone is a Market Maker Why LPs Lose Money
03The collapse of the top market maker: after the market loses liquidity
Market makers in dominoes When the market loses liquidity, how does DODO meet the market making needs? 01. Market makers in the crypto field What are market makers, how to make markets, and how to make profits?
Wikipedia explains that market makers are called "specialists" in the New York Stock Exchange market, "dealers" in the Hong Kong securities market, and "market makers" in Taiwan.
As the name suggests, a market maker is someone who creates the "market".
In traditional financial markets, a market maker is a commercial organization, usually a brokerage firm, large bank or other institution, whose main job is to create liquidity in the market by buying and selling securities.
Market making is an established and mature financial practice. In this process, market makers provide liquidity and depth to the market. Buyers and sellers do not need to wait for the counterparty to appear. As long as there is a market maker to take on the counterparty, the transaction can be concluded. Market makers earn the bid-ask spread from both parties and make a profit. The difference between the bid and ask prices in the market is the bid-ask spread, which is the main way for market makers to make profits (it can also be rebated through the trading platform. The trading platform will pay some specialized market makers to increase trading volume and increase profits).
In a liquid market with many buyers, sellers, and market makers, spreads are tight and market makers need to make a lot of trades to be profitable. They use very advanced quantitative algorithms to take very short-term positions - from hours to seconds. The more trades a market maker is able to make if the market moves big enough, the more profit they make.
It costs 103 to buy this asset, and 97 to sell this asset. The spread earned by the market maker is 6.
In short, market making is the provision of two-sided quotes to any given market, providing the market size for both buyers and sellers; without market makers, the market would be relatively illiquid, which would hinder the convenience of trading.
Market Makers in Crypto Markets
Whether in traditional markets or crypto markets, liquidity is the lifeline of all trading markets, and market makers are the helmsmen. In the crypto market, market makers are also called liquidity providers (LPs), which may directly point out that, like traditional markets, crypto markets need market makers to solve liquidity traps by helping to guide the market's "invisible hand."
This liquidity trap is mainly manifested in a vicious cycle: crypto projects need someone (cryptocurrency exchanges and crypto investors) to contribute to token liquidity; at the same time, these people will only participate when the token has market liquidity. And this is where Market Maker comes in.
Simply put, market makers breed liquidity with liquidity, and a project usually needs to leverage the support of market makers to provide liquidity, confidence, and price-raising momentum for their token markets until trading volume is sufficient for them to maintain the trading ecosystem themselves.
How professional cryptocurrency market makers solve market liquidity problems for projects Source: Wintermute What are market makers used for?
Take cryptocurrency as an example. The most important point is, of course, the liquidity that has been mentioned repeatedly, because liquidity is the foundation of any effective market.
Powerful pricing function: Market makers can track price changes over a long period of time, make judgments on the fair market price, and provide the most referenced quotes. For example, platforms like 1inch not only guide funds to different fund pools, but also invite some market makers (such as Wintermute) to quote. Enhance market liquidity: Investors can trade directly with market makers without waiting or looking for counterparties. Market making is to provide bilateral quotes to any given market, which is the core of providing liquidity. Improve the overall efficiency of the market: Market makers quote through various trading platforms, eliminate market confusion through arbitrage, and help improve the overall efficiency of the market. For example, Kairon Labs currently connects to the APIs of more than 120 exchanges, providing assistance in reducing the impact of price fluctuations. Facilitate the promotion of new tokens and reduce issuance costs: Market makers will drive the continuous increase in trading volume and the emergence of a large number of new tokens on multiple cryptocurrency exchanges. Increase trading volume and market expectations: Attract investor attention, enhance market confidence, and then drive up token prices Promote the completion of large transactions: Market makers themselves are suitable to become counterparties for institutional investors to conduct large transactions. Market making strategy
Market making strategy refers to a strategy of establishing limit buy and sell orders, using the up and down fluctuations of the underlying price to trigger the limit orders, and obtaining trading profits through the difference between the buy and sell orders. This is a risk-neutral market price spread arbitrage strategy in high-frequency trading strategies. In simple terms, it is the middleman who earns the difference mentioned above.
Twitter user 0xUnicorn analyzed the common market maker trading strategies in detail in his tweets, using spot and futures as categories, which will not be repeated here. Of course, there are also more specific categories of strategies: Delta neutral market making (that is, self-hedging inventory risk), high-frequency "instant" market making, grid market making, etc.
https://twitter.com/0xUnicorn/status/1592007930328776706
At its core, the market making strategy focuses on the number of limit orders and the distance between the buy and sell order quotes and the middle price. Therefore, in various classic market making strategies, the main research is on the estimation of the middle price, and then the buy and sell orders are set at appropriate positions on both sides of the middle price. Therefore, what market makers fear most is a sharp one-sided market trend, because it means that buy and sell orders will be traded one-sidedly, and a large number of risky positions will be accumulated.
Risk, Opportunity, and the Wild West
As mentioned above, the risk mainly comes from inventory risk.
When a large amount of inventory is accumulated on hand, it also means that there is a greater chance that the market maker will not be able to find buyers for its inventory, leading to a risk of holding more assets at the wrong time (usually in a depreciating value). Another situation is that the market maker has to start selling inventory at a loss to maintain operations when the price of the asset rises.
In DeFi, the handling of market making risks may be more cautious. For example, perpetual contracts. Market makers often use the funding rate of perpetual contracts (the core of this mechanism is to anchor the contract price to the spot price) to arbitrage spot and leverage. This arbitrage method can be summarized in one sentence: create a position with the same position value and opposite position direction in the spot/leverage and perpetual contract markets. Therefore, under abnormal price fluctuations, market makers will face great liquidation risks because the positions they hold due to different funding rate arbitrage may be large.
Opportunities come from high returns behind high risks. Even if the spread is $0.01, when such a trading order is executed one million times a day, the profit will reach $10,000. Market makers also provide leverage to traders. Once a client's position is liquidated, the market maker will be able to liquidate the trader's margin. According to Coinglass data, the amount of cryptocurrency liquidation is $100 million to $1 billion every day. This will enable market makers to make huge profits.
It is undeniable that the crypto market is still in its early stages, and compared to the very mature market-making operations in the traditional financial market, there is still a crazy side here. If we zoom in on some details of crypto trading: asset liquidity is relatively low; there is a significant risk of slippage; when large orders appear or when a large number of sell orders cancel the best buy quote in the order book, there is a high possibility of a flash crash. These characteristics often bring some hidden corners, or benefits, to crypto market making.
Overall, due to technical and regulatory factors, the crypto market and users are still in a state of confusion, like a blind man touching an elephant.
Enter the Wild West. When a market maker promises a token issuer a specific level of trading volume, the next step is an even more ambitious promise: that the token price will rise to a specific level. How?
Wash Trading: A beginner will place a large sell order and then place a buy order of their own within seconds. An advanced player will use smaller orders and leave them open for longer periods of time, and will operate from multiple accounts instead of one to avoid detection by exchanges. Pump-and-dump: Of all the price manipulation strategies, pump-and-dump is particularly common. Social networks are the best pioneers, and once fomo sentiment is high enough, large quantities of tokens purchased in advance can be sold for profit. Ramping: Ramping is to create the impression of a big buyer. Market makers can use this strategy to create a "big buyer" who trades large amounts in a fixed time period, where fomo sentiment comes in handy again, and other traders will rush to get ahead of the "big buyer" (but end up being losers) - when the market notices such behavior, the price naturally rises. Of course, once the market maker's activities are over, the ghost buyer will mysteriously disappear and the token price will most likely plummet. Cornering: When there are multiple market makers for a token, one market maker can make money by trying to buy up the majority of available tokens, forcing other market makers to raise prices because they have to keep the spread at the same level.
Due to the complete lack of regulation, these speculative operations do appear in the execution strategies of market makers, which ultimately disrupt the market, wipe out confidence in the traded assets, lose the trust of the exchanges that list the coins, affect the reputation of the project parties and lead to long-term losses.
02.Yes or No: Everyone is a market maker Market makers and automated market makers
Although market makers (MM) and automated market makers (AMM) sound similar, they are completely different entities.
As mentioned earlier, in traditional finance, a market maker is an institution or platform that proposes various securities trading transactions to multiple exchanges, provides liquidity to the market, and makes profits through the difference between buying and selling prices.
AMM is a decentralized exchange (DEX) protocol. Unlike traditional exchanges that use order books, assets are priced according to a specific pricing algorithm, and the pricing formula varies with different protocols. For example, Uniswap uses the following mathematical curve to determine the transaction price: x * y = k. Where x and y are the quantities of two assets in the liquidity pool, y is the quantity of another asset, and k is a fixed constant, meaning that the total liquidity of the pool must remain unchanged.
AMMs work similarly to traditional order book trading platforms, both of which set up trading pairs (such as ETH/DAI). However, the former does not require trading with specific counterparties. In the AMM mechanism, traders interact with smart contracts to "create" markets for themselves. Liquidity in smart contracts is provided by liquidity providers (LPs), who earn fees from transactions conducted by the trading pool in return for providing liquidity to the protocol.
AMM: Everyone is a market maker
In traditional financial terms, AMM refers to a method of simulating human market maker behavior through algorithms, but in the field of DeFi, it has gradually evolved into a violent engine:
It uses an automated algorithm to balance the supply and demand of tokens in the trading pool, avoiding the situation in the order book model where a token may be shorted (no buyers/sellers place orders in the market) due to one-sided market conditions and cannot be traded. Unlike other market makers, such as CEX market makers who make a living by taking the bid-ask spread, they will make profits by adjusting positions and controlling inventory according to their own strategies. DEX market makers provide liquidity in a different way from CEX, and they also earn fees. When this part of the transaction fee is given to liquidity providers, they will be incentivized to inject idle assets into the trading pool to provide liquidity, which to a certain extent solves the problem of insufficient trading depth in the order book model.
AMM-based DEX has proven to be one of the most influential DeFi innovations. It is the emergence of AMM that breaks the limitations of order books and matching, helping DEX break the monopoly of CEX in the cryptocurrency trading market and making open and free on-chain transactions a reality. It is also AMM that allows ordinary users to participate in market making in a permisionless way, allowing every DEX to shout out the proud slogan: everyone is a market maker.
No permission is required, efficient and transparent, the market is self-created, and everyone can enjoy the benefits of liquidity creation. The market-making vision described by DEX sounds too perfect.
Why do LPs lose money?
Now let's look at the vision and reality.
The first question is, if users become LPs and come to DEX to make markets, will they definitely make a profit? (A voice: Have you forgotten about impermanent loss?)
In a widely cited study on Uniswap v3 LP losses, rekt brutally pointed out that they (users) would be better off HODLing than providing liquidity on Uniswap v3.
As shown in the article, during the period from May 5 to September 20 when V3 was launched, 17 asset pools with TVL > $10 million (accounting for 43% of TVL) had a trading volume of more than $100B and earned about $200 million in fees for LPs. However, during the same period, more than $260 million was lost due to IL, resulting in a net loss of more than $60 million. In other words, about 50% of V3's LPs are losing money.
While Uni V3 popularized the concept of leveraged liquidity provision — where the universe of trades providing liquidity is narrowed and a higher degree of capital efficiency is achieved by eliminating unused collateral — this leverage increases the fees earned, but also increases the risk taken, as highly leveraged liquidity will be subject to higher impermanent losses.
The reason goes back to the design goal of Uni V3: customized market making. For users, higher initiative means that market making operations become more complicated. LP income depends on LP's ability to judge the market, which increases LP's decision-making costs and leads to uneven LP income. This design also gave rise to the phenomenon of JIT (Just In Time) attacks (using V3's centralized liquidity to set up the addition and withdrawal of LP positions in the same block, so that the range of positions can be strictly defined to match transactions, in order to dig out the enlarged part of the transaction fees).
Improving capital efficiency but losing returns at the same time - this is not what LPs want to see.
https://twitter.com/NateHindman/status/1457744185235288066?s=20&t=jb-YsLK25pE8GuHZaMAudg
This leads to the next question: If users come to DEX to make markets, will they definitely lose money as LPs?
Let us answer this question briefly: Whether a DEX market maker is profitable or not, in addition to the subjective ability, mainly depends on the model of the pool providing the transaction.
Traditional AMM model pools - there is no difference between the profit logic of ordinary users providing liquidity and professional market makers. The funds and external quotes of market makers are limited by the AMM function. It is essentially a competition of TVL, which determines who can share higher handling fees. Pools with customizable prices - such as Uni V3, Balancer V2, Curve V2, DODO V2. This type of pool allows market makers to actively intervene in the pool's quotes. Market makers can use these tools to make profits through the price differences and lags between CEX and DEX markets (at the same time, there are many DEX aggregators now, and better quotes mean that the pool will have a greater probability of being captured by aggregators).
One of the reasons why LPs lose money is that they choose a plan that is not suitable for them.
Why do the leading DEXs provide pools with customizable prices? It is not just Uni V3. When liquidity is evenly distributed on the curve, it will face the problem of excessive slippage and dispersed liquidity. Therefore, traditional AMMs all want to improve capital efficiency. The optimization direction of Uni V3, Balancer V2, Curve V2, and DODO V2 mentioned above is moving towards centralized liquidity.
In comparison, the advantage of active market making is that users can concentrate liquidity in a certain range by adjusting prices, etc., thereby improving capital efficiency, so the transaction slippage is lower and the depth is higher; but the disadvantage is also here. It has raised the threshold for ordinary users to participate in market making to a certain extent. It is more suitable for professional market makers. The profit may increase, but we must admit that the risk of losing money also increases. After all, ordinary users cannot compete with professional market makers in terms of professional skills and market sensitivity.
Everyone is a market maker. We need to re-understand this slogan: everyone can become a market maker, but not everyone can be a good market maker.
03. The collapse of the top market maker: after the market loses liquidity, the market makers in the domino effect
The FTX empire collapsed, and a series of leading platforms suffered heavy losses, with market makers and lending becoming the hardest hit areas: Alameda, one of the largest market makers in the cryptocurrency industry, collapsed in this farce and officially ended trading on November 10; Genesis, a market maker and lending company under DCG, suspended redemptions and new loan issuance in its lending department due to insufficient repayment capacity caused by the FTX explosion, and is seeking a $1 billion emergency loan from investors.
As a key link in the domino effect, what impact does the market maker bring?
Market liquidity has dropped significantly
FTX explosion incident - market maker collapse - liquidity gap. With the disappearance of the top market makers, it can be expected that market liquidity will drop significantly. Other market makers will also suffer more losses due to the collapse of FTX, which will further widen the gap. A corresponding cruel reality is that cryptocurrency liquidity is dominated by only a few trading companies, including Wintermute, Amber Group, B2C2, Genesis, Cumberland and Alameda. It has only been half a year since the three-arrow credit crisis in May and June. When the market is overshadowed again, market making will be difficult.
According to Kaiko’s data tracking, since CoinDesk published its investigation into Alameda’s assets, BTC liquidity within 2% of the mid-price has dropped from 11.8k BTC to 7k, the lowest level since early June. In this article, there are also many data showing that the liquidity of the entire market has been significantly affected by the collapse of Alameda and the losses suffered by other market makers.
Thankfully, the depth has recovered slightly over the past week, suggesting that market makers are redeploying capital. But it is clear that the pace is very slow.
The total amount of BTC within 2% of the mid-price has increased from 6.8k to 9.1k. In USD terms, the market depth has increased from $112 million to $150 million Source: Kaiko token liquidity and project stress testing
Alameda has invested in dozens of projects and holds millions of dollars worth of low-liquidity tokens (since Alameda is also a market maker, they are also the main liquidity provider for these tokens). Although the full details of Alameda and FTX’s holdings are not yet clear, according to the FTX balance sheet provided by the Financial Times, “it is a systemically important market maker.” Especially for the liquidity of tokens other than BTC and ETH, the extreme market conditions brought about by the crash are undoubtedly a huge stress test for these project parties.
For example, SOL (Solana), one of Alameda Research's heavily invested tokens. According to a CoinDesk report, Alameda held approximately $1.2 billion in SOL tokens on June 30. SOL was one of the best performing tokens in the 2021 bull market, but is now down 95% from its all-time high.
A collapse of this scale would: first, bring about a liquidity crunch and pose risks to the DeFi ecosystem through large-scale liquidations, and could also cause lending protocols to be saddled with bad debts; second, lead to a collapse in confidence, a large loss of staked tokens, increase the likelihood of interruptions, bring stability and security risks, and reduce the cost of network-level attacks.
In the weeks following the implosion of FTX and Alameda, SOL plummeted from about $35 to about $11, a drop of 68.5%. Source: TradingView
What is more important is the double collapse of confidence and trust.
Confidence: The "black swan" incident has impacted the industry's confidence in the so-called high-performance public chain, and has also destroyed the confidence of users and supporters in a series of ecological projects under FTX to a certain extent. Confidence is more valuable than gold, and fear is more terrifying than hell. The crypto market has experienced two Lehman moments in half a year, the Luna/Terra and Three Arrows Capital incidents, which taught users what uncertainty is and brought a panic to the crypto market that spreads faster than the virus.
Trust: In the collapse of Alameda, we can see how the industry's top market makers were running wild. For example, their entire trading business was conducted by FTX, which improperly mixed customer funds. But for investors and project parties, they had no way of knowing. Of course, this is the invisible trust that CeFi has been asking for from the public since the beginning, but when the market's once reputable, well-endorsed, and large-scale market makers also show naked ugliness, you still feel disillusioned with the trust in the crypto world. Although we have said it many times: FTX/Alameda ≠ Blockchain.
When the market loses liquidity
As mentioned earlier, liquidity is the driving force behind any market.
When the overall market trend is downward, the withdrawal of top market makers will undoubtedly make the situation worse, which means that more projects and investments tend to stagnate, and a vicious cycle will appear here (until the fundamentals recover):
Market slowdown - liquidity decline, or major crisis - sharp one-sided market - decline in market making activity - reduced trading volume and investment activity - decline in liquidity - market slowdown.
SRM and MAPS also saw a huge drop in depth, and market making activity was affected by Alameda Source: Kaiko
In order to maintain liquidity in the crypto market, many market makers provide liquidity to blockchain exchanges and financial protocols. Therefore, in the absence of market making or a sharp decline in market making activities, there may be low trading volume and reduced investment. Here we need to distinguish: liquidity will normally decline during fluctuations, because market makers extract bid/ask tasks from the order book to manage risks and avoid bad flows; but the sharp decline caused by major crisis events and market makers' withdrawal will face severe challenges for market liquidity for a period of time.
It can be seen that the current liquidity has declined more severely than in any previous market downturn, and the market recovery in the bear market has been extremely slow, which indicates that this liquidity gap may continue to exist in the short term.
So what should we do?
How does DODO meet market making needs?
As mentioned above, we actually raised two main questions:
When AMMs are all optimizing towards centralized liquidity, and when being an LP to make markets may become a challenging or even money-losing thing, how can market makers earn profits? When the FTX explosion caused the collapse of the top market makers and the decline of market liquidity, how can we rebuild trust and truly utilize the decentralized nature of the crypto world to bring scarce liquidity to the project? Bring true permissionlessness, efficiency and transparency to market makers?
As for the second question, the answer is self-evident when it is asked: Use DEX, Use Blockchain. Let's go back to the chain, back to the code, back to "don't trust, verify".
Regarding the first question, there are already many protocols or platforms in the market that provide corresponding liquidity management tools to help LPs manage risks and stabilize returns. Here may be a solution from DODO: bringing professional market makers on-chain.
In the article "Exclusive Interview with DODO Market Makers: How to Use DODO to Improve Market Making Efficiency", market maker Shadow Labs mentioned that after deducting various fees such as gas, it can obtain a net profit of 30-40% of the public income on the chain. For example, after deducting various fees, the market maker pool of WETH and USDC on DODO has a year-to-date net income of $500,000, with a net yield of about 36.2%.
So how can we do this?
As we all know, AMM is often referred to as "inert liquidity" because the price point provided to traders cannot be controlled, unlike traditional market makers who are more knowledgeable and flexible. This is where DODO intervenes, and thus pioneered the PMM (Proactive Market Making) algorithm. The PMM algorithm uses price prediction to adjust the pricing curve. The parameters are simple but extremely flexible. The flatter curve effectively improves the utilization of funds and reduces transaction slippage and impermanent loss. For the efficiency improvement of centralized liquidity by different algorithms, please refer to "In-depth Comparison of Uni V3, CurveV2, DODO Market Making Algorithms - Efficiency Improvement Brought by Centralized Liquidity".
In addition to these familiar contents, we would like to talk about the V2 version of DODO launched in March of this year. The DODO Private Pools (DPP), also known as private pools, are pools specially provided for professional market makers to make markets.
As the name implies, a private pool can be independently marketed by market makers with their own funds, and the private pool configuration can be flexibly modified during the market making process, including transaction fee rate, current external guidance price i, curve slippage coefficient K, and support for adjusting the size of the pool funds, etc. All these modifications are implemented by triggering smart contracts by relevant accounts (including two methods, calling the DODO DPPProxy contract and directly calling the underlying private pool to make market making modifications. For specific operation steps, please refer to: DODO V2 Private Pool Operation Instructions). Therefore, this pool mainly meets the market making needs of professional market makers.
In terms of yield performance, according to DODO data statistics, the total yield of WETH-USDC market makers on Polygon is 16%, and the total yield of the market maker pool on BSC (launched at the end of July) has reached 10% or even 22% in the past four months, which is quite impressive overall.
There is currently no DPP pool on Ethereum. Most market makers choose to build pools on Polygon and BSC chains with lower gas fees.
In addition, the article "In-depth Comparison of Uni V3, CurveV2, and DODO Market Making Algorithms - Efficiency Improvement Brought by Centralized Liquidity" analyzes the improvement in capital efficiency brought by centralized liquidity through the performance of liquidity distribution data. By selecting the WETH/USDC market maker pool as a sample, the article shows the average liquidity ratio between 2%, 6%, and 10% of the price range. The liquidity ratio of the DODO V2 market maker pool within the 2% range is as high as 83.1%.
Allowing professional market makers to enter the chain is the direction of future trading and market making, because decentralized exchanges are naturally trustless, non-custodial, and license-free. However, due to cost and efficiency issues, solutions based on the AMM framework have made slow progress in this regard. DODO's PMM algorithm and DPP private pool provide professional market maker teams with a highly flexible market-making curve, reduce market-making costs, improve capital efficiency, and bring an efficient market-making experience; in a market environment with declining liquidity, it also provides a better cooperation option for project parties.
references
https://foresightnews.pro/article/detail/5995
https://twitter.com/0xUnicorn/status/1592007930328776706?ref_src=twsrc^tfw|twcamp^tweetembed&ref_url=https%3A%2F%2Fwww.notion.so%2Fbe02a02105b5470e83fff8f06425e298
https://twitter.com/NateHindman/status/1457744185235288066?s=20&t=jb-YsLK25pE8GuHZaMAudg
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https://dodotopia.notion.site/DODO-DODO-97a9cbbaa925431d88f110754446cdf9
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https://newsletter.banklesshq.com/p/is-solana-dead