Gate.io Blog Science: From Market Maker to Liquidity Mining, How Important is Liquidity?

Science: From Market Maker to Liquidity Mining, How Important is Liquidity?

19 July 15:36

Abstract:The term liquidity mining has stepped into the limelight since DeFi exploded in the summer of 2020. This term did not arise out of nowhere, but is derived from traditional financial concepts such as market maker and liquidity. In this paper, I will explain market maker trading strategies, automated market makers and liquidity mining in detail for you.

Key Words: Maker Orders, Taker Orders, Market Maker, AMM, Liquidity Mining

In the third quarter of 2021, Gate.io launched its liquidity mining products with the aim of activating the sluggish trading market and providing users with an alternative investment option. With the strong support of the platform, Gate.io Liquidity Mining has a very high annualized yield, and it is one of the best crypto coin products in the sluggish market.

So what is liquidity mining? How does a liquidity mining program work? and what is the "past and present" of liquidity mining? If you want to understand these in a comprehensive and in-depth way, you have to start with the "Market Maker" in the traditional financial industry.

Three types of participants in the financial market
According to financial theory, the risk often matches the return in an effective market. the higher the return, the higher the risk. And the risk generally consists of liquidity risk and price risk. In a way, it is by taking high risks that gaining high returns can be possible for traders. From the perspective of risk-taking, traders can be roughly divided into three types. The first one is the speculator/ position trader, and the second one is the hedger, and the third one is the scalper/market maker.

Speculators take on price risk which is the risk of a sharp rise or fall in prices. They buy at low prices and sell them after the price rises; or they borrow and sell them first, and then buy back and close their positions when the price falls. If their prediction about the price movements is correct, they will make profits. Or they wil lose money.

Hedgers are often operators or producers in the real economy. They are unwilling to bear the risk of price fluctuations and tend to transfer risks to speculators. For example, concerned that the price of agricultural products will fall, farmers choose to short the futures market, by doing this, they can offset losses caused by falling prices of agricultural products with their profits in the futures market so as to lock in their own income in advance. Meanwhile, speculators in the futures market are willing to assume the price risk and hope that prices will move in the same direction as their forecasts.

The third type of participants in the market, the market maker, take on liquidity risk which is the risk of being unable to buy or sell. Market makers trade quickly and constantly with other traders in the market and earn the spread between them.

Taker Orders, Maker Orders, Spread, and Liquidity
Liquidity is fundamental to the survival of exchanges as liquidity equals popularity. A market without liquidity is just like a stagnant pool. The higher the liquidity, the faster the participant can conclude transactions, and the less price fluctuation there will be. Let's take the BTC/USDT trading pair on Gate.io as an example.

Click on the Order Book on the right side of the Gate.io trading page and you can see unfilled orders in the current market. Orders in red below the latest price are bid orders and orders in blue above are ask orders. For example, in the bitcoin order book above, the lowest bid price is $32,523.49 and the highest bid price is $32,518.79. Since the lowest bid price is higher than the highest bid price, the order cannot be filled, and the difference between the lowest bid price and the highest ask price is $4.70, which is the bid-ask spread.

Firstly, a trader will enter the quantity as well as a bid or offer for an asset on the left side of the page and submit it. Then the order will be compared to the quotes available in the market. When the price is higher than the minimum selling price of $32,523.49 for a bid order, or it is lower than the maximum buying price of $32,518.79 for an ask order, the order will be filled immediately. This situation is also called a taker. When there is no matching order in the market, it will be retained in the order book. This situation is known as a Maker.

(Click here to learn more: Gate.io Cryptopedia: Maker and Taker)

In the order book, the number of transactions involved in each order is displayed. This number is visualized as the length of the red/blue bar, which is the order depth map. The longer the color bar, the larger the volume of transactions accumulated in the order book.

Market makers often hold a certain amount of BTC/USDT positions and constantly trade in the market. For example, in order to ensure that their Maker orders will be prioritized, they may sell BTC at a price $1 lower than the lowest sell price of $32,523.49, and then buy BTC at a price $1 higher than the highest buy price of $32,518.79, making a profit of $2.70 in this way, while ensuring that the amount of BTC they hold remains unchanged. At the same time, this competition between market makers also plays a role in narrowing the spread.

The more Maker orders in the order book, the denser the distribution of orders in price, and the smaller the spread tends to be. At the same time, the more Maker orders, the deeper the order depth will be. This means that the market can "absorb" large orders with smaller price fluctuations. For example, a 2 BTC sell order will take all the orders from $32,518.79 to $32516.39. Therefore, it can be roughly said that this 2 BTC sell order caused the price to decrease by about $2. And as the order depth is deeper, there will be less impact on the price with the same large order.

This trading strategy has also derived another operation (Arbitrage) that utilizes the price differences between exchanges, commonly known as bricking. Arbitrageurs take advantage of the disparity in price movements between different exchanges, buying on low-priced exchanges and selling on high-priced exchanges, thereby smoothing out the spread between exchanges and making profits.

Computer Market-Making and Liquidity Mining
In the traditional financial field, only those securities companies with strength, credibility, and licenses are qualified to be market makers. To ensure that the transaction is at the best speed, these market makers are often equipped with high-frequency processing equipment which are placed near the exchange. However, this is not the case for virtual currency trading. Technically speaking, a trader provides liquidity to the market and becomes a market maker to some extent as long as he makes orders.

The trading strategies of market makers can also be implemented by algorithms and programs. In October 2019, the open source project team Hummingbot released what was known as "Liquidity Mining: A marketplace-based approach to market maker compensation " , in which the term Liquidity Mining was first mentioned. The Hummingbot project has developed an automated market-making program that automatically trades according to specified rules following a strategy similar to that described above. And users can run programs with their own tokens, promote transactions and earn interest margins, thereby obtaining more tokens. This behavior is somewhat similar to mining under the PoS mechanism or PoW mechanism.

The automatic market-making with a computer program is called liquidity mining by Hummingbot. But later, with the development of decentralized finance, the term of liquidity mining has been used more widely, and its meaning has shifted considerably.

Liquidity Mining and AMM Mechanism
In a centralized exchange, since the exchange holds a large amount of tokens, transactions are completed through the order book mechanism. However, this approach does not work in decentralized exchanges as they do not hold tokens themselves and their transactions are based on a public chain. Take Uniswap as an example, as the world's largest decentralized exchange, it is essentially a smart contract built on ethereum. Currently, the Ethereum network can only process 12-15 transactions per second, with block times ranging from 10 to 19 seconds. And this processing speed cannot support the high-speed and frequent transactions required by market makers.

To solve the problem of insufficient liquidity, Uniswap introduced a mechanism known as Automated Market Maker (AMM). Under this mechanism, each trading pair will be configured with a corresponding liquidity pool, and the user will automatically become a liquidity provider by injecting funds into the liquidity pool. Then the automatic market-making robot will determine the price according to the ratio of the two tokens in the pool. So the transaction will be completed at the price determined by the system. In this way, a fast, low slippage transaction can be ensured. Moreover, the liquidity provider will be rewarded with transaction fees.

Learn more about AMM mechanism:
From V1, V2 to V3, Why Is Uniswap Leading the DEX Market?
Science: What You Need to Know About Investments in Liquidity Mining Products

Under this mechanism, the user's arbitrage behavior in the decentralized exchange will eventually make the price determined by the automatic market maker approaching the price in other markets, thus acting like an Oracle. Here, we take Gate.io liquidity mining as an example. Currently, in the ETH/USDT liquidity pool, the number of ETH is 185.20 and the number of USDT is 344,618. According to the formula, the price of USDT/ETH in the liquidity pool should be 346,618 /185.20=1,871.59, which is very close to the latest price of ETH at $1875.15.

In addition to rewarding liquidity providers with transaction fees, many liquidity mining platforms will also offer additional token rewards so that liquidity providers can earn more profits.

This is the case with Gate.io Liquidity Mining. The most important benefit that Gate.io offers to users is a high return. During the promotion period, Gate.io feeds all fees generated by automated transactions to liquidity providers. At the same time, Gate.io offers rewards to liquidity providers. Conservatively speaking, the current yield of Gate.io liquidity mining products is among the top level of cryptocurrency financial products. Join Gate.io to participate and earn profits.

Click here to participate：https://www.gate.io/en/liquidity
Click here to learn how to participate: https://www.gate.io/en/article/21337
Learn more about Gate.io liquidity mining:
Gate.io Cryptopedia: How to Get Liquidity Mining Yields?
Gate.io Help CenterFAQs for AMM Liquidity Pool
Why is Gate.io Liquidity Mining Great for Low Volatility?

Author: Gate.io Researcher: Edward.H
* The article only represents the researcher’s views and does not constitute any investment advice.
* Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all other cases, legal action will be taken due to copyright infringement.

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Science: From Market Maker to Liquidity Mining, How Important is Liquidity?

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