What is a Market Maker and how they make money
March 21, 2023
In the context of crypto trading and exchanges, what is a market maker? We’ll reveal below the players and mechanics behind the simplicity of exchanges. A little tip before we begin: if you don’t know what an order book is, reading up on it will allow you to better understand this article as well as your daily trading activity.
Market making: price formation
As in any market for goods or services, prices in cryptocurrencies are formed at the intersection of supply and demand.
The market participants of an exchange who embody and create these two levers are market makers and market takers.
Who are the market takers?
When you open a buy position and it is matched by an existing sell order in the order book, you become a ‘Taker’. This is because you have accepted someone else’s offer and therefore ‘taken’ that liquidity from the order book. Market takers, unlike market makers, place more importance on the immediate execution of the order than on the terms of the order. This is why in most cases you will not see a taker’s position in the order book, as most non-expert users execute market orders, i.e. orders that are executed at the first available price, unlike limit orders.
What is a market maker and what does it do?
When you open a position that does not match an existing bid or ask in the order book, you become a ‘Maker’ because you create a new order, adding volume to the market. Market makers tend to try and buy at the lowest possible price or sell at the highest possible price.
Usually MMs are companies or professionals who receive a premium from market takers or exchanges in exchange for the constant supply of liquidity in the market.
Market makers: how they work and why they matter
Whether there is a premium or not from their client, a large part of the profit comes from the spread for market makers. What is it? Basically, they open positions at different prices on the same market, as in this example.
Say you create a sell position at €2100 and a buy position at €2000. As long as the market price is within this range, the market maker will earn the margin represented by the spread.
By providing liquidity to the market in this way, they help ensure that there is always someone willing to buy or sell a cryptocurrency at any time. The provision of liquidity in turn increases market depth, i.e. the ability to absorb large orders without increasing the volatility of an asset. To understand whether the market depth is high, simply check the depth chart of an exchange. If it is high, the chart will show large coloured areas, reflecting the amounts used in limit orders to buy and sell.
The entry of a whale in such a market will be less disruptive than in an illiquid market, as there will be many more orders ready to match its supply or demand. The volatility in response will therefore be low. This is why market makers can be very important to the health of a market.
However, market making also entails taking risks, as the maker may find themselves holding large quantities of crypto without ever making a profit if there are no buyers or sellers at ideal prices.
This is why professionals or market making companies usually diversify their positions and clients, with hedging strategies. To manage positions and make the business more profitable, these firms invest heavily in technology such as artificial intelligence with the idea of automating these transactions.
The difference between a broker and a market maker or dealer
Market makers are often confused with brokers, traders, dealers or arbitrageurs. Indeed, they have in common their involvement in the financial market and trading, in fact most of these professionals make money on the spread. What distinguishes them is the way they do it.
The main objective of the first on our list, the trader, however, is not to make money on the spread, but rather to invest and speculate on the price of an asset through various strategies, and what differentiates them fundamentally from a MM is that they do not operate with the purpose of providing liquidity to a market.
Let’s continue with brokers, intermediaries who execute trades of various financial instruments on behalf of investors. These may also choose to use their access to large liquidity to act as market makers, but this is not their main activity. On the contrary, brokers, like exchanges, may also be clients of market makers.
Dealers, on the other hand, are a category that includes MMs, as they are independent liquidity providers. The difference between dealer and market maker is that the former provides their service on a continuous basis, while the latter decides whether to provide their service on a case-by-case basis.
Finally, the difference with arbitrage is that the purpose of this activity is not to provide liquidity or volume, but to gain from price differences between various markets.
AMM: how does an automated Market Maker work?
Crypto exchanges can generally be based on two systems: either the order book or the AMM.
AMM stands for Automated Market Maker and is a solution created in the context of DeFi to make decentralised exchanges (DEX) independent of traditional MMs.
In this type of exchange, trades and liquidity are managed in an automated manner through smart contracts and through the contribution of the users themselves, in fact anyone can provide liquidity and be remunerated for it. Let’s see how.
In DEXs, exchange pairs such as ETH/USDT are each associated with their own ‘liquidity pools‘ where both currencies of the pair are deposited and locked according to a fixed ratio. From here, the liquidity needed to trade is drawn. Anyone can provide liquidity in exchange for transaction fees, and therefore there is no need for Market Makers, which can be found in centralised exchanges.
In the case of low liquidity and high volatility, the automatic mechanism also balances the supply of coins in the pair’s liquidity pool: liquidity is removed or added until the discrepancy between the best bid and best ask price is gradually rebalanced to normal market levels.
Volatility situations, if caught early, present opportunities that are highly sought after by traders operating arbitrage strategies. In addition to being profitable for the latter, this activity provides volumes to the exchange and helps the AMM bridge the gap between supply and demand that naturally arises.
Having discovered what a market maker is, how they work in crypto and the meaning of AMM, you can learn more about liquidity and its role in trading.