September 1, 2021

How Market Makers Provide Liquidity to Cryptocurrency Exchanges?

Liquidity is a vital element of the financial system and is especially important in the new and emerging industries, such as crypto, DeFi, and other digital assets. Liquidity is the ability to easily buy and sell an asset at any time, without drastically altering its price.

On any kind of exchange, sellers are matched with buyers. In liquid markets, there’s a high demand from those who want to buy an asset and a high supply from those who want to sell it, and the bid-ask spread is tight.

On the contrary, when it comes to illiquid markets, selling an asset at a fair price is hard, because there isn’t enough demand and a high bid-ask spread. Exchanges that demonstrate the highest liquidity attract more traders and investors and inevitably become more successful than the others. This is exactly why most exchanges work with market makers - to ensure sustainability and liquidity on the trading platform.

Market makers work behind the scenes acting as an intermediary between a buyer and a seller, quoting both parties the price of an asset. By bringing in a high volume of orders in seconds, they drive liquidity and reduce volatility on the exchanges. Low volume exchanges with big spreads on the order book are easier to manipulate - a big player can easily buy out the active orders and set any price he wants. Some exchanges use market makers who compete to set the best bid or offer, which keeps the bid-ask spreads tight but also helps to discover a fair price for an asset.

In the digital assets market, most newly launched or long-tail exchanges choose to partner with professional market makers, while established exchanges often incentivize market makers with low trading fees and rebates.

CEXs and DEXs are fundamentally different not only in their approach to trading, management, and KYC but also often in the ways they bootstrap liquidity and engage with market makers.

Unlocking the Liquidity for Order Book CEX and DEX

Market makers are widely adopted across order books of every major crypto exchange, absorbing the spreads between buyer and seller through fulfilling orders on both sides, allowing traders to enter and exit positions with minimal slippage. In the case of traditional order book-based cryptocurrency exchanges, liquidity is often boosted through negotiated market-making services. Parties enter contracts that define rewards and obligations for each specific provider. The promise behind the market-making services includes:

  1. Minimize bid-ask spreads
  2. Increase order book depth
  3. Reduce volatility
  4. Prevent market manipulation
  5. Entice greater volumes to the exchange

These five factors all contribute to one main objective – providing liquidity!

Liquidity provision can take several forms. In addition to traditional market-making, some companies provide order book replication, aggregating order books from multiple exchanges to deepen liquidity and tighten spreads. Other services may include spot execution and optimal trade execution, which require a market maker to shift a significant amount of assets while minimizing market disruption.

Market making is a core component of the digital assets ecosystem, and even highly liquid exchanges use these services.

Automated Market Maker – what’s the difference?

An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol that relies on a mathematical formula to set the price of an asset. AMM based DEXs (like Bancor, Uniswap, Curve, Balancer, and others) are one of the most impactful innovations behind the growth of DeFi. Instead of relying on the traditional market of buyers and sellers, AMMs allow digital assets to be traded automatically and without permission by using liquidity pools. A liquidity pool contains two assets in a trading pair. The price of each asset is determined by the relative percentage of each token in that pool.

Constant Function Market Makers (CFMMs) are the most widely used class of AMMs. Their work is based on a function, for example, X*Y=C, where X and Y are reserves of certain assets in the pool, and C is an unchangeable constant.

Uniswap V2 price curve

As opposed to trading directly with counterparty like in order book exchanges, users of AMM based DEX trade with the smart contract within the liquidity pool to get the requested tokens. Any holder of a certain amount of crypto can become a liquidity provider for the chosen exchange and earn a profit, the exchange fees are split between liquidity providers in accordance with their share in the liquidity pool.

Even though AMM protocols experienced extensive growth over the last 2 years, the volume and liquidity there are still low compared to the largest centralized exchanges. Certain risks and limitations are preventing their widespread adoption:

  1. AMMs cannot exist without traditional order book exchanges they can arbitrage against, because even sophisticated mathematical formulas cannot truly represent market sentiment.
  2. Liquidity providers may experience an “impermanent loss” if the price of an asset moves too far in a certain direction. Since AMMs don’t automatically adjust their exchange rates, arbitrage traders are needed to correct the pricing of assets in an AMM to match the external market price.Arbitrageurs are usually bots and algos that catch the best deals and trade them to the pool to maintain the balance of the curve and token prices. Even though the profit extracted by arbitrage traders is creating a loss for liquidity providers, the system basically can’t exist without them.
  3. AMMs usually require multi-token exposure from liquidity providers. They have to deposit two different tokens to supply equal liquidity on both sides of the trade.
  4. AMMs require large amounts of liquidity to achieve the same level of price slippage as traditional exchanges that use order books.

Is there a place for traditional market-makers on AMMs?

A partnership between traditional market-maker and AMM based DEX is fundamentally different from the conventional order-book market making. But there are several synergies that parties can explore.

Market makers often help token projects to get a token listed on different exchanges, including AMMs, like Uniswap. With a vast network of token issuers and partner exchanges, market makers contribute to the growth of the DeFi ecosystem bringing new token projects to the DEX and add much-needed liquidity to liquidity pools by managing tokens inventory for their clients.

As mentioned earlier, AMMs need traditional order book exchanges being relied upon for arbitrage to correct the price of assets when the liquidity pool is out of balance. If the ratio between the tokens in the liquidity pool changes significantly after a trade, the slippage goes up. Traditional market makers can utilize their trading expertise and algorithms to provide arbitrage services and take advantage of the price differences between the AMM and external crypto exchanges until it’s balanced again.

With the newest update of Uniswap, version 3, the role of market makers will become more important on DEXs. On Uniswap V3 the liquidity provider does not have to provide liquidity along the entire pricing curve but can specify price ranges in which he is willing to provide liquidity. This comes quite close to the central limit order books on centralized exchanges, meaning that the smart and fast adjusting of the liquidity ranges will be a new and important service delivered by market-makers on the newest versions of DEXs.

Fundamentally, market makers are important players in the digital assets ecosystem helping not only token projects but also Centralized (CEXs) and Decentralized (DEXs) Exchanges to sustain liquidity and attractive markets for investors.

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