How does the partnership between market makers and projects in the cryptocurrency market work?
Today's digital asset market has developed into a huge global industry, attracting more and more investors and institutions to participate. However, as the market scope continues to expand and the number of market participants increases, market stability and fairness have become an increasingly important issue.
Therefore, based on the recent Arbitrum incident, the author introduced the specific mechanism of the token market maker (MM) and the possibility of potential violations, and also put forward his personal views on the need for more disclosure of projects in this field.
Why do current crypto projects have market makers (MM) trading?
In the past, projects usually promoted liquidity by providing tokens as incentives to pools on the chain. But now, they will provide incentives to sophisticated market makers to provide liquidity on centralized exchanges (CEX).
This shift is intended to increase the efficiency of price discovery and reduce costs for all parties involved.
On CEX, price discovery is more efficient due to greater liquidity. Additionally, market makers are able to provide better buying and selling prices to buyers and sellers, making the market more attractive.
How do crypto projects incentivize market makers?
Typically, projects will provide token loans to market makers for one year, during which the tokens will be given zero-cost call options. Specifically, the project will lend tokens to market makers (usually 3-5) and require the market makers to guarantee market size and spreads during the borrowing period.
Why do projects need to lend coins to market makers?
Market makers need token loans to ensure they have sufficient inventory in their operations to handle possible excessive buying demand.
At the same time, market makers need to conduct efficient borrowing operations to offset excessive buyer demand when necessary.
Token loans often have zero or very low interest rates. While market makers need tokens to provide liquidity, they don’t want to incur huge borrowing costs.
Therefore, token lending is a common incentive mechanism that can provide market makers with the necessary tokens to support market liquidity, while also reducing the cost burden of market makers.
Why give market makers call options?
Market makers need to pay a price to provide liquidity services. Projects often choose to use tokens rather than cash to pay this price because tokens are more liquid and operable.
However, in order to prevent market makers from immediately selling tokens and thus affecting the market price and the interests of investors, project parties usually give market makers call options to achieve incentive consistency. If the price of the token rises, market makers can earn more profits, and the project side can also benefit from the appreciation of the token.
How is the strike price of a call option determined if the token has not yet started trading?
In this case, the project party will choose to set the exercise price of the call option at a premium of 50% – 100% of the index price. Since the index price can usually be determined on-chain or in other markets, the exercise price does not need to be known when the transaction is completed.
This method of setting the exercise price of call options can provide market makers and project parties with a certain degree of flexibility and can reduce transaction risks. If the token price is higher than the exercise price, the market maker can earn a profit from the difference and realize the income. If the token price is lower than the exercise price, the market maker can choose not to exercise the call option and give up the income.
The relevant mechanisms of token market makers are not malicious in themselves. The problem is that these mechanisms often do not reveal information to retail investors.
Therefore, this makes open market participants feel unfair. They may not be able to learn important information about the price and liquidity of the token, and thus suffer losses in their transactions. If the project party or market maker clearly communicates this information to investors, the entire market can be more transparent and fair, thereby reducing investor losses and increasing the confidence of market participants.
Let's take a look at the recent Arbitrum incident.
In the document, there is no mention of the token market maker’s trading terms and conditions, making it difficult for investors to understand the market maker’s actions and potential impact.
More importantly, the document does not clearly state whether Wintermute (the market maker) is an investor in Arbitrum, which may lead to conflicts of interest and moral hazard.
When making investment decisions, retail investors base their analysis and decisions on the assumption mentioned in the document that only 1.275 billion tokens are the only supply on the secondary market. But that's not the case, which leads to some unexpected situations.
1. The number of call options is unknown
These call options will essentially increase the circulating supply of the token and therefore cause the token price and liquidity to be affected.
In order to maintain market neutrality, market makers need to hedge the delta of call options by selling tokens. In the process, market makers sell large amounts of tokens, effectively increasing the supply of tokens, but this data is not publicly disclosed to investors in a timely manner.
It is reported that the hedging transactions of Wintermute (market maker) have added at least 16 million tokens to the secondary market, which is also one of the reasons leading to unstable token supply and price fluctuations.
2. The terms of OTC transactions are unknown
Another issue of concern is that the foundation sold $10 million worth of tokens through an over-the-counter transaction with Wintermute (a market maker).
However, these operations were not disclosed to retail investors before the trades took place. In fact, investors were not informed of this information until after the deal was completed.
At the same time, there is no mention in the original document whether the foundation has the right to sell tokens in such a short period of time.
3. The positioning of investors and market makers is unclear
In the case of Arbitrum, it is unclear whether Wintermute (the market maker) is an investor in the project.
Especially for retail investors, it is important to understand the relationship between investors and market makers. They should have a clear understanding of the role of market makers in the market and the sources of profits in order to correctly assess market risks and opportunities.
Here's a famous strategy from Alameda:
Retail investors suffered a double blow in this incident, first being forced to accept additional tokens being passed on to them without being notified.
Arbitrum then also tried to sneak in a fake decentralization scheme, but it was eventually discovered, causing the token price to drop.
There is a reason why an IPO in Tradfi requires a prospectus to clearly outline the following:
Number of shares outstanding;
initial public offering price;
underwriters involved in the transaction;
Profits and dividends received by the underwriters.
This information is very important to investors as it provides comprehensive and transparent information about the company and the stock to help investors make informed investment decisions.
Of course, there's another reason insider trading laws exist. Participants who hold large amounts of tokens or possess inside information are required to publicly disclose their operations in the secondary market. This helps protect market integrity and transparency.
However, in the cryptocurrency market, some non-compliant operations sometimes occur, such as placing large amounts of tokens on the market. These operations often have a negative impact on the market and cause damage to investors, which cannot be tolerated.
For the development of the token market, transparency and fairness are very important. The events of last week have done a lot of damage to the industry, and it also shows that there are some shortcomings and loopholes in the existing rules and mechanisms.
In the current token market, many investors and traders are faced with information asymmetry and market uncertainty. This situation not only affects investor confidence and interests, but may also hinder the development and innovation of the entire market.
Therefore, we need stricter supervision and more transparent market rules to promote market stability and reliability. Only by strengthening market transparency and fairness can more investors and participants be attracted to join this industry.
I believe that together we can build a social contract that requires future projects to provide more transparent and open information and rules.
As investors and participants, we can take steps to achieve this goal. For example, not buying governance tokens that do not provide sufficient information and disclosure; or guarding the fairness and transparency of the market by conducting more research, investigation, and supervision of the market.
At the same time, token issuers and market makers also need to take responsibility and provide more information and disclosures to meet the needs of investors and the market. Only through cooperation and joint efforts can the token market be made more secure, fair and reliable, thereby creating more opportunities and benefits for all market participants.
