What is a Market Maker and How Does It Work?

February 14, 2024

When choosing a crypto exchange for trading or investing, you probably want to make sure you can easily buy and sell assets at a market price. The price you sell or buy crypto depends on the demand and supply at the moment. If nobody is willing to buy your assets or sell crypto to you at the moment, that means this asset is illiquid. To ensure a sufficient level of liquidity, crypto exchanges partner with specialized companies that continuously provide bid-ask spread to specific assets. These market participants are called market makers, and their name comes from what they do - they make a market.

Cryptocurrency Market Making: How it Works

A financial company or a bank can partner with a crypto exchange to participate in its market making platform. The idea is to place buy and sell orders for specific assets and maintain the spread as short as possible. Spread - the difference between the buy and sell price - constitutes a market maker’s profit. Due to algorithmic market-making tools, they are capable of transacting lots of trades a day. Having conducted hundreds of trades, a market maker collects bid-ask-spreads into a sizeable amount, which motivates them to keep doing their work.

Every time a market maker trades (taking either buy or sell positions), they take a risk, and every time, they have to find a way to offset that risk. They do it using the following methods:

  • Dynamic hedging. Market makers continuously adjust their positions in response to changing market conditions. By dynamically rebalancing their portfolios, they offset potential losses.
  • Derivatives trading. Market makers may use derivatives such as futures and options to hedge their positions. These financial instruments allow them to take offsetting positions that act as a hedge against adverse price movements.
  • Cross-exchange arbitrage. Market making in crypto often implies arbitrage trading across different crypto exchanges. By simultaneously buying and selling the same asset on several exchanges, traders capitalize on price differences.
  • Algorithmic trading. Many market makers employ sophisticated algorithms to automate trading decisions. These algorithms incorporate risk management protocols to monitor and adjust positions in real time, reacting to market changes.

Conclusion

We should never underestimate the role of a market maker for crypto markets. As it comes from their name, market makers make markets liquid and attractive for other traders and investors. Market makers contribute to the formation of fair prices and low transaction fees. They always stand ready to buy or sell assets if there are no other counterparties, regardless of the market situation and trend.

 

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