The opacity and complexity of market making in cryptocurrency markets can be intimidating, nonetheless ensuring liquidity is critical to the growth and stability of the token economy.
This report sheds light on the current state of market making in the cryptocurrency market, providing founders with practical insights into working with market makers (MMs). Key considerations include assessing whether your project requires a market maker, criteria for selecting a market maker, and contract negotiations.
Our research insights are backed by experts in real-world project protocols, quantitative finance and market making.
Market Making Tutorial
Market making involves an institution or trader simultaneously quoting a buy (bid) and sell (offer) price for a security or asset to provide market liquidity. The bid price represents the highest price a buyer is willing to pay for a security, while the offer price represents the lowest price a seller is willing to accept for the same security. The difference between the bid and offer prices is called the spread, which represents the profit margin for the market maker.
Market makers are usually motivated to maintain tight spreads and provide liquidity to the market because this attracts more buyers and sellers, leading to higher trading volumes. In turn, higher trading volumes increase the profits of market makers.
Liquidity refers to the ease with which an asset can be bought and sold without affecting its price. A liquid market has many buyers and sellers, so there are always people willing to buy and sell an asset. Conversely, a low-liquidity market has fewer buyers and sellers, which can lead to large price swings when someone wants to buy or sell a large amount of an asset.
Great, now that we know what market makers are, what’s the problem?
The problem is that the market maker’s goal of pursuing short-term profits may not align with the project team’s goal of pursuing long-term value creation. Our goal is to help founders form a synergistic relationship with market makers and avoid building transaction structures that allow market makers to gain benefits at the expense of the project’s long-term goals.
Do you need a market maker?
Founders should first think about two questions:
1. Does my project need a market maker at the current stage?
Market makers are usually needed in the early stages of a project’s launch, such as during an Initial Exchange Offering (IEO), when initial trading volume is close to zero. Established digital assets usually have ample market-provided liquidity, which makes market makers less effective.
2. What are the benefits of working with a market maker for my project?
In other words: Does my protocol need liquidity? For a decentralized finance (DeFi) protocol designed for high-volume transactions, liquidity may be critical. Conversely, for a governance token designed for low-velocity holdings, liquidity may not be so critical.
In the latter case, a simple 50/50 Uniswap pool or other decentralized liquidity pool may be sufficient. Setting up a liquidity pool can be a simple do-it-yourself solution and requires less capital than hiring a market maker that charges a recurring service fee. Once the protocol has grown to a certain size (e.g., hundreds of thousands or millions of daily active users), the project can move to a centralized exchange such as Binance, Huobi, or Crypto.com.
Evaluate the pros and cons
When conducting a cost-benefit analysis, founders should consider their specific circumstances, including financial situation, project timeline, and token purpose:
advantage
1. Narrowing spreads: Narrowing the bid-ask spread makes trading more attractive and reduces transaction costs for both buyers and sellers. Tight spreads ensure minimal fees and slippage, providing a better trading experience.
2. Liquidity creates more liquidity: Initial liquidity fosters more liquidity, attracting more buyers and sellers to the market (“liquidity breeds liquidity”), which creates a cycle that further amplifies trading volume and liquidity.
3. Price Discovery: Liquid markets facilitate accurate price discovery, representing the true value of an asset based on the decisions of many market participants.
4. Price stability: High liquidity can reduce the sharp fluctuations in prices caused by large orders and enhance investor confidence. In order to maintain the long-term vision of the project, users ideally price the intrinsic utility and value of the token, rather than viewing it purely as a speculative asset (which may be the case when prices are highly volatile).
cost
1. Participation Fees: Market makers may require setup fees, recurring fees, or token borrowing. For example, GSR, a leading cryptocurrency market maker, charges a $100,000 setup fee, $20,000 in monthly fees, plus $1 million in Bitcoin and Ethereum loans.
(Block unicorn note: Setup fees usually refer to the one-time fees that market makers need to pay before they start providing market making services to founders or project parties after signing a contract with them. This may include the fees required for market makers to create and configure trading strategies and other preparatory work for market making for the project.
Recurring fees are fees that market makers need to pay periodically (such as monthly or annually) in the process of providing market making services to projects. This may include the fees required for market makers to maintain and manage trading strategies and provide ongoing market making services to projects. These fees are usually fixed and have nothing to do with the number or amount of actual transactions made by the market maker)
2. Unbalanced trades: Founders or token issuers are often in a weaker negotiating position due to the low volume of their trading pairs (less profitable for market makers). In such cases, market makers can use this to force a more skewed trade.
3. Bad Actors: The lack of regulation in the crypto industry may attract fraudulent market makers that engage in fraudulent activities, such as wash trading or abusive token lending. The risk of harm from misconduct or default by market makers should be considered.
Criteria for selecting market makers for tokens
There are currently over 50 major market makers in the cryptocurrency/web3 space. When choosing a market maker, we recommend referring to the following 5 key criteria:
1. Fees: This includes the sum of setup fees, recurring fees, performance-based fees, and options.
2. Capacity (volume and spread): The volume or spread of the quote initially provided by the market maker. Market makers may only guarantee quotes during certain hours of the day, while some market makers are available 24/7.
3. Reputation: Established companies with large balance sheets, a good track record (e.g., partnerships with prestigious projects, traditional finance experience), and experience in market making in delta-neutral markets.
4. Accessibility: Criteria set by the market makers themselves when selecting markets to trade on (e.g., market makers with a minimum volume threshold for an asset).
5. Partnerships: Reliable connections with major exchanges (Binance, Huobi, Crypto.com), which may help with exchange listings, which must be considered carefully and conservatively.
Market Maker Contract Terms
The final step is to negotiate and finalize the contract outlining the terms of the market making agreement, also known as the Liquidity Advisory Agreement (LCA).
By analyzing both public and private market making protocols, we identified key factors in the protocol that any project founder should focus on:
Remuneration
We define compensation as any form of financial incentive designed to reward market makers for proactive behavior. We identify three main forms of compensation across multiple market making transactions: 1) service fees, 2) options, and 3) fees based on key performance indicators (KPIs).
Service Fee
The fixed fee paid to market makers can be a sizeable fiat sum for early stage projects. There are several pricing structures:
1. Setup Fee: A large one-time payment made to a market maker at the start of a service contract.
2. Reserve Fee: A fee paid to a market maker on a regular basis (e.g. monthly, bi-weekly, quarterly) – this is usually a specified fixed rate.
3. There are both setup fees and reserve fees (reserving market making services).
4. No Fees: In a bull market, market makers may choose not to charge any form of fees, especially for popular tokens. Supply and demand dynamics determine the cost of market making as a whole, and hyped tokens are profitable enough for market makers to not require further fees.
Founders should be aware that market makers often have negotiating leverage for a number of reasons:
Rich market selection: Market makers can trade in many different markets, so losing a deal with one project has limited impact on their business.
Limited profit margins for early projects: For early projects with limited existing trading volume or liquidity in their native tokens, market makers see limited profit opportunities and potential risks in providing services. Market makers use high-frequency algorithmic trading to make profits, so when trading volume is limited (when liquidity is lacking), this opportunity is less attractive to market makers.
Options
Options are common in market maker agreements, providing financial returns to the market maker through token price performance. Typically, this gives the market maker the option to purchase the token at a pre-negotiated price after the loan matures.
Therefore, market makers have an incentive to keep the price above a certain threshold (the option’s strike price) because this gives the market maker the ability to exercise the option to purchase a certain number of tokens at the pre-specified strike price and immediately sell them at the higher current market price, making a significant profit.
Market makers use options to convince founders to sign agreements with them, suggesting that using options can align them with the success of the token (i.e. token price appreciation). This is particularly common in bull markets, where early-stage project tokens have the potential to grow 100x, and market makers work harder to secure options trades (and usually succeed).
However, these options become worthless upon expiration and such alignment is always short-term for market makers.
Using options as a market maker's compensation is complex and risky for the following reasons:
1. Pricing Challenges: Determining a reasonable strike price, option duration, or volatility for a new asset is difficult and prone to large inaccuracies. In a bull market, the goal of market makers is to negotiate huge option packages at low prices and get returns from token price increases in a similar way to venture capital.
2. Manipulation Risk: For founders with limited financial/statistical knowledge, they may fall victim to manipulation of key parameters of option value. They may not even be aware that the options they are offering have a price/implied value attached to them - similar to the difficulty in valuing equity in startups.
- Unethical market makers can underestimate the actual value of options by using unrealistic assumptions in their calculations, causing founders to unintentionally give up more value. This can be achieved by using unreasonable assumptions (e.g., the volatility of the token will be equal to the volatility of Bitcoin), which means that the value of the option in the contract is actually significantly lower than the actual situation.
Special reminder: While token founders do not need to learn complex statistics and option pricing theory, there are tools that can be used to roughly estimate the value of token options in contracts. It is difficult to accurately determine the value of your option transaction, but founders should understand the value provided in order to have a more transparent and informed discussion with market makers.
There are tools and methods that can be used to estimate the value of options, such as calculators or simulators based on option pricing models. Founders can use these tools to generate a rough valuation range to better understand the value of options. However, it should be noted that these valuations are for reference only, and the actual option value may be affected by a variety of factors, including market conditions, the development of the project, and the interest motivations of market makers.
Founders should strive to understand the value of option trading and have a more transparent and informed position when discussing with market makers. This will better protect the long-term interests of the project and ensure that transactions with market makers reach a relatively fair and profitable agreement.
We have created a basic tool to aid in estimating and valuing option contracts: The Paperclip Option Pricing Tool
There may be a risk of price manipulation:
1. If options are overpriced, then this will encourage market makers to push prices higher.
2. If the option price is too low, then the market maker (if the loan repayment model is based on the number of tokens) can maximize profits by short selling the tokens, and only need to repay part of the principal in the end.
One possible form of option pricing is to use “tranches”, where the token issuer offers several options with different strike prices or expiration dates. For example, GenesysGo, which signed a contract with Alameda, offers three tranches priced at $1.88/$1.95/$2.05 respectively.
Interestingly, segments have little to no tangible impact on the actual service. Nonetheless, they exist for two reasons: a) market makers want to make trading more complex and thus appear more “legitimate.” b) market makers may want to offer slightly better trading conditions than their competitors.
Performance-based fees
Key Performance Indicators (KPIs) can be used to create performance-based fees that reward market makers for achieving the goals desired by the project. Some performance indicators (and our assessment of them) are listed below:
1. Trading volume
Volume as a metric carries significant risk because it can incentivize wash trading, a practice that is illegal in most markets and can create misleading market data, artificially inflating volume figures.
2. Price
As an indicator this is not ideal as it could lead to market makers pushing up token prices, which then risks collapsing the ecosystem when prices fall back.
3. Price difference
a. The spread or bid-ask spread is the difference between the quotes to sell immediately and to buy immediately for a stock. In other words, it is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to sell for.
b. Generally speaking, this is a relatively reliable KPI, although it needs to be supplemented with some indicators that capture the market depth (otherwise spreads are narrow but prices are easily swayed).
4. Minimum buy and sell size (in USD)
a. Minimum buy and sell sizes refer to the value that market makers are willing to buy and sell in USD (value of project tokens).
b. This is an important key performance indicator that ensures that there is a reasonable buffer when large orders cause large price fluctuations, preventing prices from easily skyrocketing or crashing.
Comparing different forms of compensation
The decision of which form of compensation to choose in a project is ultimately highly individual and depends on the amount of money the founders have on hand, their goals for decentralization and governance, and the stage of the project.
Visualization of compensation mechanisms: Fees generally have higher certainty (expressed in dollar value) relative to options, as measured by a "certainty" or "average cost" metric, but can increase significantly depending on market conditions. However, in a bull market, call options can easily inflate to extremely high values if the price of the underlying token skyrockets.
Service fees (including setup fees and monthly recurring fees) are a balanced arrangement, but high initial fees may be required to increase liquidity support for the project from well-known market makers (MMs). However, setting vague targets for these fees is not ideal. Combining performance-based fees with specific targets, such as spread percentages, can better align the behavior of market makers with project goals. However, care should be taken to avoid using easily manipulated KPIs, such as trading volume, during the negotiation process.
——We recommend that risk-averse teams combine service fees with KPI-based bonuses. Cash-strapped projects should look for small and medium-sized market makers that have proven to be trustworthy, while well-funded projects should sign contracts with large top-tier market makers and strive to negotiate mainly on fixed terms.
Compensation through options can lead to overpayment for market makers’ services and increase risk. Another negative outcome concerns governance: if founders issue a large number of options to market makers at low strike prices, market makers may accumulate a large amount of circulating supply. This can harm the decentralization of the protocol, especially because market makers tend to vote with the goal of maximizing profits rather than aligning with the vision of the project.
- For teams with tight funds but high risk tolerance, a certain amount of options can be considered in the reward package, but pay attention to the present value of the options. However, if the project has considerable cash reserves and a loyal user base, it is generally not recommended to use options, and thorough scenario testing is required to avoid overpayment.
The following is a summary of the above:
A framework for understanding the trading risks of market makers is that as a founder, you need to consider what the market maker will gain or lose if the price of the project token increases 1,000 times, or if the price of the project token drops to zero.
Assuming that market makers will always act with the goal of maximizing profits and returns, the team should be able to understand the motivations of market makers in driving prices. Ideally, market makers should be neutral to price direction as their goal is only to provide liquidity.
Loan Terms
In a market making agreement, a common arrangement is that the asset issuer or the party requesting liquidity services provides a loan to the market maker for the market maker to use for trading and liquidity provision of tokens. Several elements of the loan terms are of great significance:
1. Loan term: The length of the loan term is important because it determines how long the project has to wait before the market maker returns the loaned capital. This should be negotiated on a case-by-case basis based on the project’s roadmap and the core team’s financial needs.
2. Interest Rate: This token loan is based on a 0% interest rate because market makers receive variable returns when they make trades, which is not attractive if they also have to pay fixed interest.
3. Token loan quantity and value: If the token used in the loan is consistent with the ecosystem native token, the incentive alignment will be stronger. However, it is important to note that loans based on the number of tokens have adverse incentives for market makers, who will benefit if the token price drops because the repayment amount will be less valuable. This contractual provision is similar to an "embedded option" in that it gives market makers a large potential gain from a significant price drop before the expiration date.
4. Repayment issue: The project party should clearly stipulate the contractual obligations that will arise if the market maker is unable to return the tokens. The contract terms usually also include payment of the outstanding amount in BTC/ETH or stablecoins.
Right of Termination
1. Notice period
Typically, each party can terminate the agreement by giving a certain period of written notice. As with many commercial agreements, the period of notice for termination is usually between 14 and 30 days. However, each issuer should assess the ease of obtaining additional market makers based on its individual circumstances and adjust the notice period accordingly. Other conditions under which the parties can terminate the agreement
2. Asset Issuer
a. The right to terminate the Agreement in the event of a material breach of its obligations.
Market Makers: Market makers have more significant termination rights as they determine the conditions under which they can no longer provide liquidity. We outline four possible termination conditions and comment on key considerations for the core team where applicable.
1. Payment terms default: Issuers should ensure that safeguards exist, including grace periods, to provide a buffer for teams in the event that funding conditions deteriorate.
2. Breach of other terms (e.g., confidentiality agreement).
3. Conflict with the terms of service and regulations of the exchanges providing liquidity.
4. Laws and Regulations: As the regulatory environment in the cryptocurrency space is constantly changing, market makers need to protect themselves in case the performance of their obligations suddenly becomes a criminal offense. One source of potential legal due diligence is to understand the laws governing market making in traditional asset markets, which can set precedents for future Web3 regulatory approaches.
responsibility
In most liquidity agreements with market makers, the market makers are usually exempted from any liability related to token price fluctuations. This is to be expected due to the speculative nature of cryptocurrencies, while it is important to note that there are countless factors beyond the control of the market maker that can determine the price of a token, so it is fundamentally unreasonable to hold the market maker responsible for the financial consequences of such price fluctuations.
in conclusion
In summary, market making plays a key role in ensuring liquidity and stability in the cryptocurrency market. This report aims to uncover the complexities of market making in cryptocurrency markets and provide actionable insights for founders considering working with market makers. Through analysis of real contracts and insights from industry experts, this report highlights the need to consider market makers, the importance of choosing the right firm, and negotiating terms.
We hope that this report will be a valuable resource for founders and other stakeholders in the cryptocurrency ecosystem, helping them make informed decisions about market making and driving growth and stability in the token economy.