Crypto Market Making: Strategies for Maintaining Liquidity | Bookmap (2024)

Market making is about providing the grease that keeps the wheels of crypto markets turning. In the ever-volatile cryptocurrency market, liquidity concerns have always been paramount. Therefore, to ensure adequate liquidity in crypto markets, market-making is often employed. This technique involves the continuous provision of buy and sell quotes, ensuring active trading opportunities are always available.

In this article, we will learn the essential aspects of market-making in the context of cryptocurrency trading. We start by defining market making and then study some of its key strategies, including algorithmic trading to automate transactions and manage risk and spread management techniques to optimize profitability.

Moreover, we will check some regulatory considerations, such as compliance with anti-money laundering (AML) and know-your-customer (KYC) requirements. Also, we have highlighted the importance of managing volatility and liquidity risks while providing some practical examples of how market makers tackle these challenges. Let’s get started.

What is the Crypto Market Making?

Market making is providing liquidity to a market by continuously quoting buy and sell prices. When it comes to cryptocurrencies, market makers ensure there is sufficient liquidity for trading various digital assets. For a better understanding, let’s look at the role of market makers.

What is the Role of Market Makers?

• Ensuring Market Liquidity
  • Market makers contribute to the market by placing simultaneous buy (bid) and sell (ask) orders for a particular cryptocurrency.
  • This placement ensures that there are always opportunities for other traders to buy or sell their assets without significant delays.
• Tightening Bid-Ask Spreads
  • Market makers constantly update their buy and sell prices.
  • This way, they narrow the difference between:
    • The highest price a buyer is willing to pay (bid)

and

• The lowest price a seller is willing to accept (ask).

• For the unaware, a tighter bid-ask spread indicates a more efficient and liquid market, which is usually more attractive for traders.

• Facilitating Smoother Trading Operations
  • Market makers provide a steady flow of buy and sell orders.
  • This consistent flow reduces volatility and helps stabilize the market.
  • Also, it allows traders to execute large orders without causing significant price fluctuations.

For more clarity, let’s study an example showing how market makers influence the market:

Say there is a cryptocurrency called CryptoX. A market maker places a buy order at $50 and a sell order at $51 for CryptoX. Here’s how they operate:

• Placing Orders
  • The market maker places a:
    • Buy order for 100 CryptoX tokens at $50

and

• Sell order for 100 CryptoX tokens at $51.

• Maintaining Liquidity
  • As traders buy CryptoX at $51, the market maker sells their tokens.
  • Simultaneously, they replenish their inventory by buying CryptoX at $50 from other traders.
  • This process ensures continuous availability of buy and sell orders.
• Adjusting Prices
  • If the market price of CryptoX starts rising, the market maker may adjust their buy and sell orders to $51 (buy) and $52 (sell) to reflect the new market conditions.
  • This constant adjustment helps maintain liquidity and tight bid-ask spreads.

Note: It’s important to note that market makers perform these actions to ensure that traders can easily buy and sell assets at fair prices with minimal obstacles.

Key Strategies for Effective Crypto Market-Making

Market making refers to the act of continuously providing buy (bid) and sell (ask) quotes. This practice ensures:

• Liquidity

and

• Smooth trading operations.

These quotes are placed by market makers, who play a critical role in maintaining market efficiency, especially in volatile markets. Given below are some common examples of market makers:

• Large hedge funds,
• Proprietary trading firms, and
• Specialized crypto market-making firms like
  • Jump Trading, and
  • Alameda Research.

Most of these firms use sophisticated algorithms and trading strategies to provide liquidity and profit from the bid-ask spread. To enhance understanding, let’s study a real-world example:

• During the COVID-19 pandemic and the subsequent market frenzy around GameStop and other stocks, Robinhood offered no-fee trading.
• This was possible because Robinhood sold trading information to market makers.
• These market makers then profited from the bid-ask spreads.

This example clearly shows how market makers operate in both traditional and crypto markets and benefit from their ability to provide liquidity and capitalize on market movements. Now, let’s look at some key strategies that can be employed for effective market-making in cryptocurrency.

What are Some Key Strategies for Effective Crypto Market Making?

It is pertinent to note that market-making strategies are crucial for:

• Maintaining liquidity,
• Managing risk, and
• Optimizing profitability.

By following these proven strategies, market makers continuously provide liquidity by placing buy and sell orders, which ensures smooth trading operations. Let’s look at some popular market-making strategies:

Strategy I: Spread Management

Be aware that managing bid-ask spreads is crucial for market makers. This management ensures profitability while maintaining competitive pricing. Usually, tight spreads attract traders by minimizing transaction costs, which makes the market more appealing to participants. However, wider spreads protect market makers from volatility risks. Also, they ensure that market makers are compensated for the increased risk of rapid price movements. Let’s understand better through an example:

Scenario

• During a major news announcement or an economic shock, the volatility of Bitcoin increases substantially.
• Normally, the market maker maintains a spread of $50, with buy orders at $10,000 and sell orders at $10,050.
• However, due to the heightened uncertainty and rapid price changes, the market maker adjusts the spread to $150.
• This means they now place buy orders at $10,000 and sell orders at $10,150.

Impact

• Risk Mitigation:
  • The wider spread helps protect the market maker from adverse price swings.
  • If Bitcoin’s price suddenly drops to $9,900 or spikes to $10,200, the market maker is less likely to incur a loss.
  • This is because the wider spread provides a cushion against such movements.
• Liquidity Provision
  • Although the spread is wider, the market maker continues to provide liquidity.
  • This provision ensures that buy and sell orders are available for traders.
• Market Stability
  • By adjusting the spread, the market maker helps stabilize the market.
  • While the wider spread reflects the increased risk, it also:
    • Signals to traders of the current market conditions

and

• Encourages them to trade more cautiously.

Strategy II: Inventory Management

Effective inventory management involves tracking and adjusting positions so that market makers can avoid excessive exposure to market risk and maintain sufficient liquidity. See the graphic below to understand some key guidelines of this strategy:

It is important to note that market makers use sophisticated algorithms and automated tools to monitor their inventory in real time. These tools help maintain a balanced inventory. Also, their use ensures that market makers can:

• Quickly respond to market changes

and

• Manage their positions efficiently.

Let’s understand better through an example:

Consider a market maker operating in the Bitcoin market. They have a predetermined risk threshold for their Bitcoin holdings, set at a maximum exposure of 100 BTC. To manage this, they use specialized software to continuously monitor their inventory and market conditions.

Scenario

• Real-Time Monitoring: The software tracks the market maker’s Bitcoin holdings in real-time, along with:
  • Current market prices

and

• Trading volumes.

• Threshold Breach: If the market maker’s exposure to Bitcoin exceeds the 100 BTC threshold due to an influx of buy orders, the software triggers an automated response.
• Automated Adjustment: The software executes a series of sell orders to reduce the Bitcoin holdings within the acceptable range. For example,
  • If the exposure rises to 120 BTC, the software may sell 25 BTC to lower the exposure to 95 BTC.
  • This way, it allows for some buffer.
• Risk Management
  • This automated process ensures that the market maker does not hold excessive Bitcoin.
  • This helps mitigate the risk of significant losses due to price volatility.
• Maintaining Liquidity
  • By adjusting their inventory in real-time, the market maker ensures they have sufficient liquidity to continue fulfilling trades.
  • This kind of liquidity maintenance provides a reliable market for other participants.

Strategy III: Dynamic Pricing

Dynamic pricing algorithms allow market makers to adjust their quotes in response to:

• Market conditions

and

• Competitor actions.

These algorithms analyze real-time data and order flow to optimize pricing strategies. By continuously updating prices based on the latest market information, market makers ensure their quotes remain competitive and in line with current demand and supply dynamics. To make this clearer, let’s consider an example for better understanding:

Consider a market maker operating in the Ethereum market. The market maker uses a dynamic pricing model that updates quotes based on real-time market data. This is how the algorithm works:

• The algorithm continuously monitors real-time market data, including:
  • The volume of buy and sell orders,
  • Price movements, and
  • Competitor quotes.
• If there is a sudden influx of buy orders for Ethereum, indicating increased demand, the algorithm detects this change.
• To capitalize on the increased demand, the algorithm raises the ask price for Ethereum. For example,
  • Say the initial ask price was $2,000.
  • Now, the algorithm might increase it to $2,050 to maximize profits from the higher demand.
• The algorithm can also adjust the bid price simultaneously to attract more sellers. For example,
  • Say the initial bid price was $1,990.
  • Now, the algorithm might increase it to $2,010 to ensure the market maker can acquire more Ethereum to meet the increased buy orders.

Some Practical Examples Showing Market Making During Volatile Periods

Example I: Volatility Management

Scenario

• In early 2021, the price of Bitcoin experienced a significant surge.
• This increase happened because institutional investors showed a greater interest in Bitcoin.
• Such an interest created significant volatility in the market.

Impact

• Increased Risk:
  • The rapid price changes increased the risk for market makers.
  • The risk increased because holding large inventories of Bitcoin became more unpredictable.
• Widening Spreads:
  • To manage this risk, market makers widened their bid-ask spreads.
  • For example,
    • Say the typical spread was $50.
    • The market makers increased it to $150 or more during periods of extreme volatility.
    • This adjustment helped to cushion against rapid price swings and potential losses.
• Adapting Quotes
  • Market makers continuously adapted their quotes based on real-time market data.
  • This adaptation ensured they could still provide liquidity while protecting themselves from adverse price movements.

Example II: Robinhood Example: No-Fee Trading During the COVID-19 Pandemic

The no-fee trading model of Robinhood during the COVID-19 pandemic and the GameStop/Reddit situation presents an excellent illustration of market making. Let’s study in detail:

• During the COVID-19 pandemic, the trading frenzy around GameStop (fueled by Reddit communities) led to extreme volatility in the stock’s price.
• Robinhood provided user trading data to market makers. This data included information about buy and sell orders, which market makers used to adjust their strategies.
• Market makers used this data to provide liquidity. They ensured that buying and selling orders were always available for Robinhood users.
• Market makers profited from the bid-ask spread without charging users directly. For example,
  • If Robinhood users bought GameStop at $150 and sold at $148, the market makers would profit from this $2 spread.
• Robinhood’s no-fee trading model attracted a large number of retail investors, which increased the volume of trade. Market makers benefited from this increased activity by earning more from the spreads while ensuring continuous liquidity.

Advanced Market-Making Techniques

Two popular advanced market-making techniques are:

• Statistical arbitrage

and

• Algorithmic trading.

Statistical arbitrage allows market makers to exploit temporary price discrepancies between correlated assets like Bitcoin and Ethereum, while algorithmic trading automates the continuous monitoring and quote adjustment process based on real-time market conditions. Both these techniques are essential for maintaining:

• Liquidity

and

• Competitiveness in the dynamic cryptocurrency markets.

Let’s understand both these techniques in detail:

1. I) Statistical Arbitrage

This advanced strategy uses statistical models to identify and exploit pricing inefficiencies between correlated assets. This technique allows market makers to profit from temporary price discrepancies. For improved comprehension, let’s understand the practical application through an example highlighting statistical arbitrage between Bitcoin and Ethereum.

• A market maker identifies a strong historical correlation between
  • Bitcoin (BTC)

and

• Ethereum (ETH).

• They use statistical models to monitor the price relationship and detect any deviations from the norm.
• The market maker’s model detects a temporary pricing inefficiency where BTC is undervalued relative to ETH based on historical patterns. For example,
  • Say the usual ratio is 30 ETH per BTC.
  • However, the current market shows 32 ETH per BTC.
  • Now, this suggests BTC might be undervalued, or we can say ETH is overvalued.
• The market maker buys BTC and simultaneously sells ETH.
• Market makers do so as they expect the prices to revert to their historical correlation.
• Once the prices adjust, the market maker closes the positions by:
  • Buying back ETH

and

• Selling BTC at adjusted rates.

• If the prices return to the normal ratio of 30 ETH per BTC, the market maker profits from the difference.
• Market makers profit because they have:
  • Bought BTC at a lower effective price

and

• Sold ETH at a higher effective price.

1. II) Algorithmic Trading

Algorithmic trading involves the use of computer algorithms to automate trading activities. Most market makers use algorithms to:

• Continuously monitor

and

• Update their quotes based on real-time market conditions.

Now, let’s learn the practical implementation of an Algorithmic Strategy in easy steps:

• Step I: Algorithm Development
  • The market maker develops an algorithm that incorporates various market signals.
  • Some common signals include:
    • Order book depth,
    • Trade volume,
    • Price volatility, and
    • Competitor quotes.
  • The algorithm is designed to adjust bid and ask prices dynamically.
• Step II: Continuous Monitoring
  • The algorithm continuously monitors the market.
  • It analyzes real-time data to detect changes in market conditions.
  • For example,
    • Say there is an increase in buy orders for a particular cryptocurrency.
    • The algorithm adjusts the ask price upwards to capitalize on the demand.
• Step III: Quote Adjustment
  • The algorithm updates the bid and ask quotes, based on predefined criteria.
  • For example,
    • Say the bid-ask spread needs to be maintained at a certain level to stay competitive.
    • Now, the algorithm makes the necessary adjustments automatically.
• Step IV: Risk Management
  • The algorithm also incorporates risk management rules, such as setting:
    • Maximum inventory levels

and

• Stop-loss limits.

• If the market becomes highly volatile, the algorithm widens the spreads to protect against rapid price changes.

• Step V: Execution
  • As market conditions change, the algorithm executes trades to maintain the desired inventory levels and profitability.
  • For example,
    • Say the algorithm detects that the market price of Bitcoin is rising quickly.
    • Now, it executes sell orders at progressively higher prices to maximize profit while ensuring liquidity.

How to Manage Risk in the Crypto Market Making?

To manage risks in the crypto market, market makers employ different strategies to handle:

• Volatility

and

• Liquidity risks.

The two most popular such strategies are:

• Hedging Techniques
  • Market makers use hedging techniques to protect against price volatility.
  • This involves taking offsetting positions in related assets to mitigate potential losses.
• Volatility Forecasting:
  • Forecasting future volatility helps market makers anticipate and prepare for market movements.
  • Statistical models and historical data analysis are commonly used for this purpose.

Let’s understand better through an example showing how to use Futures Contracts for Hedging:

• Say a market maker holds 100 Bitcoin (BTC).
• To hedge against potential price drops, they use Bitcoin futures contracts.
• Each futures contract represents 1 BTC, so they sell 100 futures contracts.
• As a part of the hedging strategy, they sell an equivalent number of BTC futures contracts.
• Now, assume the price of BTC drops.
• This drop causes the value of their BTC inventory to decrease.
• However, the short futures position gains value, which, in turn, offsets the loss.

In the above example, it must be noted that the gains from the futures contracts compensate for the losses in the BTC inventory, thus hedging against price volatility.

How to Manage Liquidity Risk Challenges?

Liquidity Risk occurs when a market maker cannot buy or sell assets quickly enough to prevent significant losses. This risk can be mitigated by:

For more comprehension, let’s study an example showing how a market maker diversified liquidity provisions:

• Say a market maker operates in the Ethereum (ETH) market.
• The market maker primarily trades on Exchange A, which has high liquidity.
• However, Exchange A experienced a sudden liquidity crunch, significantly widening the bid-ask spreads.
• The market maker also trades on Exchanges B, C, and D.
• During the liquidity crunch on Exchange A, they shift their trading activity to these other exchanges.

From the above example, we can observe that by distributing their liquidity provision across multiple venues, the market maker can continue to operate smoothly. This strategy reduces the impact of the liquidity crunch on Exchange A.

Regulatory Considerations

It’s important to note that adhering to regulatory requirements in different jurisdictions is crucial for market makers. Usually, non-compliance leads to severe penalties, including:

• Fines
• Loss of licenses, and
• Damage to reputation.

See the graphic to learn about two basic regulatory requirements:

How to Avoid Market Manipulation?

Market makers must avoid practices that could be seen as market manipulation, such as:

• Wash trading: Simultaneously buying and selling the same asset to create misleading trading activity.

or

• Spoofing: Placing large orders with the intention of canceling them before execution to manipulate prices.

One must be aware that these practices are illegal and undermine market integrity.

Some Guidelines for Ethical Market-Making Practices

• Transparency: Maintain transparent operations by documenting all trading activities and making records available for regulatory scrutiny.
• Fair Trading: Ensure that all trading practices are fair and do not deceive or manipulate other market participants.
• Best Practices: Follow industry best practices for market making, including
  • Maintaining reasonable bid-ask spreads

and

• Avoiding artificial price movements.

• Regulatory Compliance:
  • Regularly review and update compliance policies to align with the latest regulations.
  • Engage in continuous education so compliance teams stay informed about regulatory changes.
• Internal Audits:
  • Conduct regular internal audits to ensure trading activities comply with regulatory standards.
  • Use third-party auditors for an unbiased assessment.
• Ethical Training:
  • Provide training for employees on ethical trading practices and the importance of market integrity.
  • Ensure that all team members understand the consequences of market manipulation.

Conclusion

Market makers continuously provide buy and sell orders in the market. This liquidity provision ensures the smooth execution of transactions at competitive prices. It also enhances market efficiency and mitigates price volatility, creating a more stable trading environment.

Furthermore, market makers must also understand that effective market-making strategies are vital for sustaining liquidity in cryptocurrency markets. Some key strategies include algorithmic trading to automate and optimize trading activities, managing risk through hedging and diversification, and adhering to regulatory compliance to maintain market integrity.

These strategies allow market makers to deal with the complexities of crypto markets effectively while supporting ongoing market liquidity and accessibility for participants. For further insights into market-making dynamics, check out this interview with CryptoIntel.