Background Knowledge

Liquidity is a fundamental concept in financial markets that refers to the ease and speed of buying or selling assets without significantly affecting their market prices. A market with high liquidity allows traders to execute transactions quickly without causing substantial price fluctuations. Market makers are crucial in providing liquidity by consistently offering buy and sell quotes. They are always ready to buy or sell assets, serving as counterparties for other traders and enhancing market activity and liquidity.

In traditional financial markets, market makers are usually large financial institutions or professional trading firms. They provide market depth, help maintain market liquidity and stability, facilitate price discovery, and offer convenience to traders, making the market more efficient and orderly.

The cryptocurrency market is still relatively new, with a smaller user base and lower trading volumes. As a result, it is more prone to liquidity challenges. Insufficient liquidity can cause increased price volatility, wider bid-ask spreads, and higher trading costs. In the world of cryptocurrencies, the market is decentralized, with multiple trading platforms, and participants’ behavior may be more unpredictable and irrational, further aggravating liquidity issues.

Delving into the World of Crypto Market Makers

Crypto market makers provide abundant liquidity to the crypto world and generate profits through buying and selling cryptocurrencies, primarily from bid-ask spreads. Let’s simplify the process by assuming market makers provide liquidity for Bitcoin (BTC) on a trading platform:

1. Setting Buy and Sell Prices:
   1. Market makers set buy and sell prices on the trading platform. For example, a market maker may set a buy price at $40,000 and a sell price at $40,100.
2. Execution of Trades:
   1. When other traders accept these prices and execute trades, market makers profit from the transactions.
   2. For instance, if one trader buys 1 BTC from the market maker for $40,100, and another sells 1 BTC to the market maker for $40,000, the market maker earns a profit of $100 (excluding transaction fees and other costs).
3. Continuous Provision of Liquidity:
   1. Market makers continually update their buy and sell prices and adjust their trading strategies based on market conditions to ensure ongoing profitability.

In practice, market makers may employ sophisticated algorithms and strategies to manage their orders and risks, maximizing profits while minimizing losses. They may also leverage additional incentives from trading platforms, such as liquidity mining rewards, to further increase their income. Through these means, market makers not only provide necessary liquidity to the market but also profit from bid-ask spreads, gaining returns for their services.

Without regulations in the crypto market, cryptocurrency spreads can be significant, with high market volatility and unstable income. Thus, crypto market makers have additional sources of revenue, and their client base includes crypto projects and trading platforms:

Crypto Projects

1. Over-the-Counter (OTC) Trading Services: Market makers provide OTC trading services to assist crypto projects in increasing liquidity and trading volume, thereby generating revenue. Profits mainly come from bid-ask spreads and transaction fees.
2. Becoming Token Liquidity Providers: Market makers collaborate with crypto projects as liquidity providers for their tokens, participating in liquidity mining activities. As token liquidity increases, market makers receive tokens as rewards. Additionally, by providing market depth, and participating in airdrops and market promotions by the crypto projects, market makers can earn additional income.

Trading Platform

1. Market Maker Incentives: To attract market makers to participate in market making, some cryptocurrency exchanges offer market maker incentives. When market makers place orders in the exchange’s market and meet certain trading volume requirements, they can receive incentives provided by the exchange. This is one of the ways market makers generate income. For example, Gate provides similar incentives for market makers.
2. The liquidity Provider: Market makers enhance market liquidity by providing buying and selling services for cryptocurrencies, helping trading platforms attract more users and increase trading volume. As a result, some cryptocurrency exchanges pay additional liquidity fees to market makers.

If you want to learn more about Gate’s market-making recruitment program, please click on Market Maker Benefits and How to Apply

In addition to providing liquidity, crypto market makers have other functions and roles, such as:

1. Narrowing the Bid-Ask Spread: By facilitating active trading, market makers help to reduce the gap between buying and selling prices, thereby lowering users’ trading costs and improving market efficiency.
2. Market Depth and Stability: Through continuous buying and selling activities, market makers provide depth to the market, helping to stabilize market prices and mitigate the impact of short-term price fluctuations.
3. Price Discovery and Information Efficiency: Market makers participate in the price discovery process through their trading activities, contributing to more accurate market prices that reflect the underlying value of assets and market information.
4. Facilitating Trading: The liquidity and trading opportunities provided by market makers attract more traders to participate in the market, thereby increasing market activity and vibrancy.

Overall, the presence of crypto market makers adds vitality to the crypto world and serves as a bridge for crypto trading. Based on their degree of decentralization, crypto market makers can be divided into centralized market makers and decentralized automated market makers (AMMs).

Centralized Market Makers

Development History

The development process of centralized cryptocurrency market makers can be traced back to the early stages of Bitcoin and other cryptocurrencies. Although the process was not actively segmented by participants, it can be roughly divided into four stages based on market size:

1. Early Stage (2009-2013): In this stage, Bitcoin and a few other cryptocurrencies started to emerge. Due to the small market size and lack of participants, market liquidity was very low.
2. Market Maturity Stage (2014-2017): With the emergence of more cryptocurrencies and trading platforms, centralized market makers began to gain prominence. They increased market liquidity by providing buy and sell quotes while profiting from the bid-ask spread.
3. Rise of Decentralized Trading (2017-2020): In this stage, decentralized exchanges (DEXs) such as Uniswap and SushiSwap started to rise. This prompted market makers to explore the possibilities of decentralized market making, such as providing liquidity through automated market maker (AMM) models.
4. Further Industry Development (2020-present): With the continuous maturation of the cryptocurrency market and the gradual clarification of the regulatory environment, more traditional financial institutions and professional market makers have started to enter the cryptocurrency market. At the same time, cryptocurrency market makers have also adopted more advanced and complex market-making strategies and technologies to improve efficiency and reduce risks.

Over time, centralized cryptocurrency market makers continue to innovate and adopt new technologies and strategies to optimize their services. For example, they may use machine learning and artificial intelligence technologies to predict market trends or use smart contracts and on-chain data to optimize market-making strategies. Meanwhile, their services are expanding beyond just trading platforms, gradually extending to over-the-counter trading and decentralized exchange platforms. Additionally, some centralized market makers not only provide market-making services but also offer services such as arbitrage and asset management.

Overall, the development process of cryptocurrency market makers reflects the entire cryptocurrency market’s journey from the early stage to gradual maturity. In the future, with the continuous development of the cryptocurrency market and further improvement of the regulatory environment, cryptocurrency market makers are expected to continue playing a crucial role in improving market liquidity and promoting market development.

Examples of Typical Centralized Market Makers

Jump Trading

Founded in 1999 and headquartered in Chicago, Jump Trading specializes in market making in options markets, futures, forex, and fixed income, among other areas. In recent years, Jump Trading has also ventured into the cryptocurrency market through its subsidiary Jump Crypto, offering services related to cryptocurrencies and blockchain, including market making, liquidity provision, and assistance in developing new cryptocurrency trading technologies and platforms.

DWF Labs

DWF Labs is a global digital asset market maker and multi-stage Web3 investment company. The company trades spot and derivative markets on over 60 top-tier exchanges. DWF Labs provides support for solutions ranging from token listing to market making to OTC trading.

GSR Market

GSR Markets is a global digital asset trading firm established in 2013, providing liquidity, risk management, and structured products to participants in the global digital asset ecosystem. The company offers a range of financial services for the cryptocurrency market, including programmatic execution, risk management, market liquidity, trading, and other services. In addition to its role as a market maker in the cryptocurrency market, GSR Markets also serves as a partner and active, multi-stage investor in the ecosystem.

Wintermute

Founded in 2017, Wintermute primarily develops cryptocurrency trading platforms, creating liquid markets and enabling professional market-making in the cryptocurrency market through advanced trading algorithms and technologies. Wintermute is also an active participant in the ecosystem, investing in early-stage DeFi projects, providing liquidity services to high-profile blockchain projects, and supporting the building of decentralized finance.

Advantages

The main advantage of centralized market makers is their ability to provide high liquidity. Many trading platforms prefer collaborating with centralized market makers to maintain high liquidity, facilitate fast trading at desired prices, reduce slippage risk, and ensure efficient market participation.

Additionally, centralized market makers often offer customized services and customer support. Users can choose different market makers or different strategies from the same market maker based on factors such as fees, market-making methods, and platforms. Market-making teams usually consist of domain experts who can provide more professional services.

There are also potential impact factors, such as brand promotion. Finding a reputable market maker can enhance the market’s recognition of the token liquidity, contributing to building a positive brand image. Furthermore, market makers have extensive service experience, which can help clients connect with more resources. For example, some projects can gain faster access to centralized trading platforms after partnering with well-known market makers.

Limitations

The main problem with centralized market makers is their lack of transparency, which is caused by the absence of regulation in the cryptocurrency market. Most cryptocurrency market makers do not have the same level of comprehensive and standardized regulation as traditional market makers. This can lead to some centralized market makers maliciously manipulating liquidity after collaborating with project teams, resulting in the “cornering” effect and causing significant losses for investors through price manipulation.

Another important risk is security and technological risk. Since the primary technological architecture of centralized market makers is built on proprietary servers, and asset custody is also centralized, any security risk or technical operational issues can have a huge impact on the stakeholders’ interests in the tokens.

Lastly, there is the issue of cost. Many market makers have different fees for projects and trading platforms. In addition to tokens, there may also be options and loan limits. Besides one-time fees, there may also be recurring fees (a type of periodic fee) that need to be charged, which can be expensive for some project teams.

Decentralized Market Makers

Development History

Decentralized market makers refer to projects that provide market-making services without centralized organization or company management. They are typically designed based on the Automated Market Maker (AMM) technology framework. The formal development of decentralized market makers came after centralized market makers and is closely related to the development of decentralized exchanges (DEX). The overall development can be summarized into four stages:

Early DEX and AMM Attempts

The earliest DEX can be traced back to 2014, driven by the Counterparty protocol based on the Bitcoin blockchain. However, due to a small market environment and ecosystem, it did not gain significant attention.

In August 2018, Bancor introduced the idea of building an automated market maker to disrupt order book-style trading markets. Although Bancor was a pioneer in using the AMM model, its low trading volume affected the profitability of liquidity providers, leading to a vicious cycle of low liquidity and high slippage.

Rise of Uniswap and DEX Explosion

Uniswap was launched in November 2018, and by February 2019, its trading volume surpassed Bancor. Uniswap’s design was more efficient and user-friendly, supporting permissionless listing of crypto assets and establishing a large degree of composability within the broader DeFi ecosystem.

In 2018, DEX trading volume experienced explosive growth, reaching $2.7 billion. In 2019, despite a slight contraction in trading volume, it still exceeded $2.5 billion.

AMM and DEX Development in 2020

In the first half of 2020, several important DEX and AMM projects such as Aave, Curve, Balancer, and Uniswap v2 were launched. With Compound introducing liquidity mining and the integration of lending with DEX, it brought new vitality to DeFi.

The liquidity war between Uniswap and SushiSwap, along with the UNI token airdrop, further fueled the rapid growth of the total market capitalization of DeFi projects, as well as the exponential increase in DEX trading volume and user count.

Rise of Cross-Chain DEX and Continuous Development of Aggregators

With the emergence of various Layer 1 blockchains and Ethereum Layer 2 networks, more and more DEXs have appeared, along with improved AMM algorithms and various cross-chain solutions. Additionally, with liquidity being dispersed across different DEXs, aggregator products like 1inch have emerged, allowing users to find the best trading path without manually searching for liquidity.

Up to this point, a considerable number of DEXs have appeared in the market, along with various AMM algorithms, further promoting the prosperity of DeFi. However, challenges such as impermanent loss and capital inefficiency still exist, and the market is constantly optimizing AMM algorithms to address and improve these issues.

Examples of Typical AMM Service Provider

Uniswap

Uniswap’s initial version, V1, used an algorithm called Constant Product Market Maker (CPMM) to calculate the proportional quantities of tokens staked in the liquidity pool smart contract, providing continuous quotes. The working principle can be simplified as the application of the mathematical formula X * Y = K.

X and Y represent the quantities of the two tokens in the liquidity pool, while K is a fixed value. If we plot it on a Cartesian coordinate system, we can see that it forms a hyperbola. When users exchange assets through the liquidity pool, it only causes changes in the quantities of token X and token Y in the pool, while the total liquidity K remains unaffected. Thus, the token prices move along the hyperbola. When users pay token X to acquire token Y from the pool, they can calculate the relative price between token Y and token X by dividing the acquired quantity of token Y by the paid quantity of token X.

Source: Gate Learn article《What is Uniswap》

Due to its mathematical properties, the total liquidity in the CPMM-designed liquidity pool of a DEX increases, making the pool more resilient to price fluctuations caused by user swaps and reducing slippage (the difference between the executed price and the expected price) for users. Conversely, decreasing the total liquidity in the pool makes it more susceptible to price changes from user swaps, resulting in increased slippage.

If you want to learn more about the technical details and related information of Uniswap, please refer to the Gate Learn article “What is Uniswap“

Curve

Curve, launched in 2020, aims to provide traders with a low-cost, low-slippage, and high-liquidity AMM exchange. Curve introduced the StableSwap algorithm, suitable for establishing liquidity pools for 1:1 pegged assets, especially stablecoins. Unlike the aforementioned CPMM, the StableSwap algorithm uses a simplified trading curve that approximates a straight line when the price of the trading pair is close to 1:1, reducing trading slippage. When the price deviates from 1:1, the curve becomes steeper to protect liquidity providers from losses.

Comparison of the Stableswap curve with the other two algorithms (Source: StableSwap Whitepaper)

The benefit of this algorithm is that it concentrates liquidity around the current price, reducing slippage and allowing large trades without significantly impacting the price. However, when assets experience deviations from their peg, the StableSwap curve is steeper compared to other algorithms, which means it further encourages deviations from the peg.

If you want to learn more about Curve, you can read the Gate Learn article “What is Curve?“

Balancer

Balancer further improves the AMM algorithm of Uniswap and adds many features. Under the design framework of Balancer, liquidity providers and market makers can create a highly customizable trading pool with multiple custom functions and advantages. First, it allows for fee customization, where the transaction fee can be set lower or higher compared to Uniswap’s fixed fee of 0.3%. Second, it allows for custom asset ratios, enabling liquidity to be added to the pool in any proportion, whereas Uniswap requires a 1:1 ratio. Furthermore, Balancer supports the addition of up to 8 assets in a single pool, while Uniswap only allows for 2 assets per pool. This design enables Balancer’s multi-asset pools to function like index funds, allowing passive investments.

If you want to learn more about Balancer, please read the Gate Learn article “ What is Balancer (BAL)“.

Advantages

Based on the core principles of AMM, we can compare it to centralized market makers and highlight the following advantages:

• No trust and permission required: AMMs provide a completely permissionless and trustless trading environment without the need for traders to register or undergo identity verification.
• Lower barrier for liquidity providers: Anyone can become a liquidity provider by depositing their assets into liquidity pools to earn transaction fees, which provides additional liquidity to the market.
• Trading efficiency: AMMs offer fast, simple, and efficient trading experiences, especially with sufficient liquidity.
• Market transparency: All trades and liquidity provisions occur on-chain, providing users complete transparency.
• Openness and composability: AMMs can seamlessly integrate with other protocols and platforms within the DeFi ecosystem, creating endless possibilities for users and developers.

Limitations

Due to technological and algorithmic reasons, transparent and open AMMs have some inherent limitations:

• Limited price discovery mechanism: Since AMMs rely on fixed mathematical formulas to determine prices, they may not accurately reflect real-time market prices, especially during periods of high market volatility.
• Liquidity fragmentation: Liquidity in AMMs may be fragmented across multiple liquidity pools, which can lead to insufficient liquidity and increased trading slippage.
• Low capital efficiency: Compared to traditional market makers, AMMs have lower capital efficiency as they require liquidity providers to lock up a significant amount of capital to maintain market liquidity.
• Smart contract risks: AMMs rely on smart contract execution, which carries the risk of contract errors or security vulnerabilities.
• Impermanent loss: Liquidity providers may face the risk of impermanent loss, especially when asset prices experience significant fluctuations. The majority of impermanent loss comes from uncompensated losses.

If you want to learn more about impermanent loss, please refer to the Gate Blog article “What Is Impermanent Loss?“.

Comparison between Centralized and Decentralized Market Makers

After the introduction above, we understand both centralized and decentralized market makers. These two different market-making approaches have differences in various aspects, and understanding their differences can help project teams choose the appropriate market-making strategy and gain more insights during the project research.

Liquidity Provision Mechanism

Centralized market makers primarily provide liquidity using their own funds or funds from clients. Besides holding assets, they often have access to additional funds through borrowing, allowing them to provide liquidity. On the other hand, decentralized market makers source liquidity from user pools. For example, on Uniswap, anyone can create their own liquidity pool by setting the parameters of a smart contract deployed on the blockchain.

Capital Requirement

Centralized market makers need significant capital to provide liquidity as they have to deploy liquidity across multiple trading platforms and manage it centrally. In contrast, decentralized market-making protocols do not have a liquidity scale requirement, and even a small amount of capital can be used to start a liquidity pool.

Profit Model

Centralized market makers often have a diverse range of services, including investment, incubation, and marketing, in addition to market-making. They can also engage in derivatives market-making. On the other hand, decentralized market makers typically focus on spot market-making and only deploy liquidity.

Risk Management

Centralized market makers usually have risk management departments to handle risk. In contrast, decentralized market makers primarily rely on technical measures, such as open-sourcing their code and undergoing audits by auditing firms, to manage risk.

Transaction Speed and Efficiency

Centralized market makers often utilize specialized high-frequency trading technology frameworks, faster APIs, and dedicated connections with trading platforms, enabling them to achieve higher transaction speed and efficiency. In contrast, decentralized market makers require on-chain confirmation, which usually results in slower transaction speed and efficiency.

User Interface and Experience

Centralized market makers typically do not have separate interfaces for retail users (i.e., individual investors and traders). Instead, they provide liquidity directly to trading platforms or DEXs, and users access liquidity through these platforms. Decentralized market-making protocols, on the other hand, are often provided with user-friendly interfaces that allow users to directly engage in operations such as trading, adding liquidity, and withdrawing liquidity.

Fees

Centralized market makers often have various fee structures. For many project teams, in addition to a one-time service charge, regular fees for maintaining liquidity may also be required, making them more suitable for medium to large projects. Decentralized market-making protocols, on the other hand, allow for simpler operations, such as deploying liquidity through AMMs, and can also attract other holders to join the liquidity pool, resulting in token-locking effects. This makes them more suitable for initial liquidity provision for small to micro projects.

Pricing Mechanism

Centralized market makers typically use complex algorithms to set buy and sell prices, which may consider market demand, supply, and other macroeconomic factors. Additionally, as many token issuers are their clients, customer demand is also taken into account when pricing. Decentralized market-making protocols, on the other hand, generally use fixed market-making algorithms, such as the Constant Product Market Maker (CPMM) mentioned earlier. The deployment process and contract deployment are transparent and open to the public.

Transparency

The transparency of centralized market makers may be limited as their operations and pricing models may not be fully disclosed, and there may be some degree of human intervention in their operations, which could affect the fairness and transparency of prices. Decentralized market-making protocols are fully open and transparent, allowing anyone to view their source code and transaction records, providing a higher level of openness and transparency.

Future Trends and Industry Outlook for Crypto Market Making

From the perspective of market makers, regulation remains an important issue. In the cryptocurrency market, where liquidity is largely dependent on BTC and ETH, the small size of the market often leads to a potential market crisis when major market makers face problems, as they are not subject to regulation like traditional market makers.

For instance, Alameda Research was once a major market maker in the cryptocurrency field, providing liquidity worth billions of dollars for tokens of varying market capitalization. However, both the associated FTX exchange and Alameda Research faced a crisis of trust and liquidity, ultimately resulting in bankruptcy. This not only affected industry confidence and the perception of the cryptocurrency industry by the public, but also caused a significant drop in liquidity. Therefore, introducing regulation is considered a future development trend and one of the key trends in the cryptocurrency industry.

According to data from TheBlock, DEX accounts for less than 15% of trading volume compared to CEX. There is still great potential for DEX. From the chart below, we can also see another trend in the AMM field - mature AMM DEX occupies the majority of the market share. Uniswap has become the absolute leader in the DEX field, consistently holding over 50% of the market share. The top 3 DEX accounts for over 85% of on-chain trading. Although there is innovation in the AMM field, trading volume is still dominated by giants like Uniswap, Pancake Swap, and Curve. However, as industry leaders, they are constantly innovating. For example, Uniswap has undergone three updates and recently launched Uniswap V4, as well as the aggregator UniswapX.

Source：https://www.theblock.co/data/decentralized-finance/dex-non-custodial

Market makers provide liquidity and also benefit from it. Currently, during the bear market, many cryptocurrency market makers have been affected in terms of profits and client numbers. Taking on-chain liquidity as an example, according to data from DeFiLlama, the total value locked (TVL) in DeFi (including AMM pool assets) has dropped from its peak of $200 billion to $40 billion, a decrease of nearly 80%. It can be predicted that when the macro environment improves, the profits of cryptocurrency market makers are expected to further increase.

Source：https://defillama.com/

In the future, with the application of more innovative technologies such as off-chain scaling solutions and cross-chain technology, as well as the involvement of more traditional financial institutions, we anticipate that cryptocurrency market makers will achieve optimization and upgrades in multiple dimensions. At the same time, with the expansion of the market size and the increase in user base, cryptocurrency market makers will face stricter regulations and higher market expectations, which will drive them to continually improve service quality and enhance market transparency and fairness.

Conclusion

Centralized and decentralized market makers each demonstrate their unique advantages and limitations, while also complementing each other, collectively driving the liquidity growth and progress of the cryptocurrency market. With continuous technological advancements and sounder regulations, the role and influence of cryptocurrency market makers will continue to expand, providing stronger support for the entire digital asset ecosystem.