Market making is the act of providing bid and ask quotes and sizes for an asset on an exchange. Given volatility and limited two-sided flow, Crypto market makers generally seek to meet bid-ask spread, top of book, and uptime KPIs to earn fees while keeping risk low.
Market makers use proprietary software called engines or bots to show two-sided quotes to the market, with engines constantly adjusting bids and asks based on token price changes. Not only does the liquidity provided by market makers improve price discovery, price volatility, and slippage costs, but it also performs a pivotal function in the Crypto Ecosystem, as tokens are what makes the technology work.
Market making by professional firms had traditionally taken place on centralised exchanges like Coinbase and Binance, which aggregate orders into a central limit order book and match them on a price-time priority. Market makers, however, are increasingly providing liquidity on decentralised venues as well.
While cost and speed limitations of many layer one Blockchains make central limit order books impractical, decentralised exchanges often use liquidity pools with user-contributed funds available for trading, typically following a constant product market maker pricing function.
The Cryptocurrency market has many unique characteristics, leading to various challenges when providing liquidity. For example, Crypto markets are open 24/7/365, allow for self-custody, offer fast settlement and display lower derivatives activity relative to traditional finance, are still largely unregulated, and continue to be highly fragmented with liquidity bifurcated across many on and off-chain venues.
These lead to challenges for market makers such as market fragmentation, poor capital efficiency, regulatory uncertainty, and still-improving exchange technology.
Cryptocurrency and market making continues to evolve at a breakneck pace. Going forward and spurred by regulation, institutional demand will likely continue to grow, making liquidity even more important.
And unlike the fully funded order books of today, capital efficiency should improve, at centralised exchanges via Crypto prime brokerage services and more developed repo markets, and at decentralised exchanges with concentrated liquidity, undercollateralized lending, liquid staking, and cross-protocol margining.
Moreover, the prevalence of decentralised derivatives is likely to grow, as is DeFi more generally, with market makers increasingly active in both. And within DeFi, token projects will likely increasingly use decentralised liquidity direction applications like Curve, Tokemak, and Fei/Ondo or provide their own liquidity altogether via protocol controlled value. Lastly, the lines between centralised and decentralised finance are likely to blur, with the best liquidity providers agnostic as to whether price discovery occurs on or off-chain.