As there are numerous cryptocurrency and token projects of all shapes and sizes, there is certainly not a one-fits-all crypto market making strategy. Generally, advancements in algorithmic trading technology and quantitative research have proven to be a positive shift in turning financial markets more liquid.
Crypto market making strategies can be specifically interesting, as they often come with lesser operational costs due to fees only being applied to taker trades on many exchanges for example. On the other hand, the highly volatile nature of digital assets may reduce the effectiveness of some trading strategies. This begs the question: What are common goals and strategies in market making for cryptocurrencies and tokens?
Before diving into more detail, the goals of a crypto market maker need to be understood. For any order-book based exchange, these are best expressed through performance indicators like spread, depth, uptime etc.
Most importantly, the objective of market making in crypto is to quote both bid and ask limit orders (passive offers to buy and sell) at a preferably small difference – the so-called spread. On average, the spreads are usually higher for illiquid assets, because the market maker is taking a higher risk. For that reason, projects often chose to work with a professional market making service provider who is experienced in managing illiquid tokens.
Besides the spread, it is important to quote prices at multiple price levels and with a certain depth. The order book depth allows traders to view where orders are placed or bunched in real time, and how they affect the price. Good performance in spread and depth will lead to seamless execution of trades with minimum slippage and price impact.
For an efficient price discovery, the funds that are dedicated for liquidity may be subject to volatility and a changing inventory distribution. Risk management practices should not only be implemented on a company decision making level, but also into the crypto market making strategies themselves. Through these measures, capital can be protected from malicious flow like pump and dumps and the market maker can take profit from arbitrage opportunities before external parties do so at the cost of a token issuers funds. This also ensures that prices across multiple venues and trading pairs are constantly in sync.
While trading volume itself is not a primary goal of crypto market making strategies, it certainly is a side product that is valued by both crypto projects and exchanges. Reason being, that a highly traded asset indicates interest by investors which may lead to price appreciation. It should be understood though, that the act of creating artificial or fake volume (wash trading) is forbidden in traditional markets and does not provide a liquid market, because the fake volume is created through trading against oneself within the spread. A market-makers goal is therefore to provide the lifeblood of any crypto asset: liquidity. Once liquid, people may come in and trade against a market maker. This slowly but sustainably increases organic trading over time.
On a high level, strategies vary depending on existing trading volume or the number of professional traders and proprietary trading firms in the market. The latter is specifically relevant for large cap token projects where these individuals or companies use sophisticated trading strategies to generate profits. Market makers stay competitive by utilizing high frequency trading software (HFT) and infrastructure to monitor and analyze data that is then fed it to their market-making trading models. An extraordinarily good latency can be one deciding factor to have an edge over competition. Also, top projects often work with multiple designated market makers (DMMs) to cover all their exchanges and trading pairs. Smaller, more illiquid tokens may find their market maker volume taking up a very large share of the overall volume.
Providing detailed information about crypto market making strategies would go far beyond the scope of this blog. In fact, universities and quantitative researchers provide a wide spectrum of in-depth sources on the matter. For this reason, we are only sharing a brief overview of some fields and strategies:
Also called exchange remarketing, this strategy provides bids and asks on a maker exchange while hedging trades on one or more taker exchanges.
Puts the capital dedicated to liquidity at more risk but reduces complexity. This is often performed by simple market making bots.
Hedging directional risks by offloading trades or trading assets or derivatives whose price movements offset each other. This results in a zero net change in value, while still generating spread returns.
Following this strategy, a trader would place a series of increasing buy and sell orders at predetermined price levels (“grid intervals”) below and above the market or moving average price. As orders are often further apart, they are filled less often but may provide greater spread returns.
So, how can I use crypto market making strategies for my own trading you may ask? A good first step we can recommend is becoming more familiar with Python programming. As a functional programming language that can be extended to dynamic algorithms and machine learning, it is very common among retail and institutional algo traders. Compared to other programming languages it is much more intuitive to learn, and there are lots of free resources on the web (e.g. GitHub, Youtube) that can help you get some inspiration for your own crypto market-making strategies.
Of course a disclaimer on risks should be made. If you are entering the crypto market making space, there will be many established quantitative trading firms who are competing with each other. For starters it may be wise to choose a niche market on a more illiquid exchange, where you can offload risk between an instrument pair that is also traded on another exchange with certain degrees of correlation/cointegration by selling on one venue while buying on the other (Two-Legged-Trading).