Understanding Crypto Market Making: A Beginner’s Guide
In Brief
Market making in cryptocurrency involves providing continuous buy and sell orders to ensure liquidity, stabilize prices, and enable smooth trading on both centralized and decentralized exchanges.
If you’re new to the world of cryptocurrency, you’ve probably heard the term “market making” tossed around in discussions about exchanges and liquidity. But what does it really mean? At its core, market making is the process of providing buy and sell orders on trading platforms to ensure there’s always someone ready to trade with you. This keeps pricing more stable by reducing volatility and makes it easier for traders to buy or sell tokens instantly without major price gaps.
Market makers are the unsung heroes working behind the scenes on both centralized exchanges (like Binance) and decentralized ones (like Uniswap). They bridge the gap between buyers and sellers, earning a profit from the small difference in prices known as the bid-ask spread. Understanding the fundamentals behind this process isn’t just academic: it can help you maximize profits by knowing where to trade – and where to fade.
Spoiler alert: look for where the liquidity’s deepest. That isn’t always obvious at first sight – but it should be by the time you’ve read this guide. Let’s begin.
A Quick History of Crypto Market Making
Market making isn’t a crypto invention; it’s been around since the early days of traditional finance. Back in the stock market era, human traders on exchange floors would stand ready to buy or sell securities, ensuring trades could be executed promptly. With the rise of electronic trading in the late 20th century, algorithms took over, making the process faster and more efficient. A few years later, and as cryptocurrency matured and went mainstream, market makers began to move in.
Early centralized exchanges needed constant liquidity to satisfy the demands of global users, so specialist firms stepped up to the plate. Decentralized finance – DeFi – then emerged in 2020, starting on Ethereum, and adding a twist to crypto liquidity provision: now anyone could join in, using smart contracts to place their tokens into a liquidity pool and earn a share of the trading fees. Despite this innovation, DeFi is also dependent upon professional market makers to provide deep liquidity and to match bids and asks on orderbook-based decentralized exchanges.
Today, market makers are deeply embedded into the crypto landscape, both on centralized and decentralized exchanges. They provide liquidity for everything from major pairs such as BTC/USDT to niche altcoins that are only hours old, helping to maintain a smooth trading experience no matter how calm – or volatile – the markets.
How Market Making Works in Crypto
In simple terms, a market maker quotes two prices: the “bid” – which is what they’re willing to pay to buy a particular asset – and the “ask,” which is what they charge to sell the asset. The difference – the spread – is their potential profit. When you place an order, the market maker fills it instantly, using automated systems to adjust pricing and other parameters based on market conditions.
Crypto market making occurs in two main arenas:
- Centralized Exchanges (CEXs): These are platforms like Coinbase or Binance, where professional market makers (sometimes hired by the exchange itself) use high-tech algorithms to provide liquidity. They handle high volumes and aim to stay “delta neutral,” meaning they don’t bet on price directions – they just profit from the flow of trades.
- Decentralized Exchanges (DEXs): On platforms like Uniswap or Jupiter, liquidity comes from pools where market makers – as well as ordinary users – lock in pairs of tokens (e.g. ETH and USDT). Smart contracts automate the trades and anyone can contribute. This democratizes the process, but it also introduces risks such as impermanent loss, where the value of your locked tokens changes due to price shifts.
How Market Makers Operate Onchain
One common misconception is that market makers manipulate prices or prop them up to prevent a particular token from “dumping.” In reality, they’re neutral players who follow the market’s ebb and flow, providing stability without steering the ship.
Market makers have a particularly valuable role to play when a token has just launched on a DEX, since initial liquidity would otherwise be low because users can’t provide liquidity themselves until they’ve had a chance to buy the token. To solve this chicken-and-egg problem, the token project will often provide a tranche of native tokens to a market maker. They’ll combine this with a base currency such as ETH or USDT and use it to provide liquidity from launch.
The launch of a highly anticipated new token attracts high volume resulting in significant volatility. Market makers can’t prevent this from occurring altogether, since “price discovery” is an organic part of the process when any popular token is listed on an exchange. By ensuring there is sufficient liquidity in place to facilitate this trading frenzy, however, market makers can dampen the worst of the volatility and ensure that traders aren’t adversely affected by slippage.
Once a project has stabilized, and onchain users have had a chance to provide liquidity, the market maker can take a step back. Rather than withdraw all their liquidity in one go, they’ll reduce it gradually to ensure a smooth transition that won’t impair the trading experience. Often, they’ll continue to provide liquidity for several months at the request of the project in question.
Key Strategies for Market Makers
Market makers aren’t one-size-fits-all; they use different approaches depending on the asset, exchange, and conditions. The methodology they deploy will vary according to the needs of the client who’s hired them. This could be an exchange or it might be a project that has a native token it would like to have supported in the form of liquidity provision.
Here’s a rundown of some of the primary strategies they employ:
Passive Market Making
This is the most common approach whereby the market maker places buy orders below the current price and sell orders above it, then waits for trades to come in. It’s ideal for stable markets with assets like major stablecoins or top cryptos. Profits come steadily from the spread, and it’s self-sustaining, eliminating the need for constant tweaks. If there’s a downside it’s that major price jumps – such as when a whale places a huge buy order – can leave the market maker with unbalanced holdings, but in high-volume pairs, this strategy delivers reliable returns, often 0.05-0.1% per trade.
Active Market Making
For more dynamic environments, such as volatile altcoins during a market surge, active strategies are preferable. Here, algorithms constantly monitor volatility and order books, adjusting positions in real-time. This might involve predicting short-term moves or pairing with arbitrage tactics. Active market making is more profitable in choppy waters – potentially 10-15% monthly during a bull run – but requires advanced tech and carries higher risks if the market outpaces the system.
Inventory Management
This isn’t a market making strategy per se but a smart overlay on others. Market makers track their overall holdings across assets and exchanges to avoid getting stuck with too much of a risky token. Using risk models, they hedge positions and maintain balance, prioritizing long-term survival over quick wins. It’s like portfolio management for pros: done right, it can cut risk by 30-40%, though being too cautious might limit monthly returns to 1-2%.
High-Frequency Market Making
Geared toward speed demons, this technique uses ultra-fast bots to exploit tiny price flickers in milliseconds. It’s common on liquid CEXs for big pairs, requiring low-latency setups and often run by firms from traditional finance. Profits can hit 3-5% monthly, but setup costs are steep and it’s a strategy that’s not used by delta-neutral market makers – rather it’s the preserve of private trading firms using their own initiative for profit maximization.
Demystifying Crypto Market Making
Market making is the glue holding crypto trading together, from smoothing out CEX orders to keeping DeFi pools deep enough for whales to swim. As a beginner, grasping these concepts empowers you to trade smarter and even contribute, should you decide to pool liquidity to earn rewards. For the most part, you don’t need to concern yourself with the finer points of market making: but you should at least be aware of the signs that show it’s in place on the exchange where you’re operating.
Whether trading on DEX or CEX, the price you’re quoted for a particular token should be extremely close to the final price you pay, and the difference between the bid and the ask should be nominal. If you receive an alert warning you that slippage is higher than 1% on the exchange where you’re about to make a swap, think twice before proceeding. Where possible, go elsewhere to make your trade – to a DEX or CEX where the price you’re quoted is the price your order is filled at. Nine times out of ten, when this happens it’s evidence that there’s a market maker in the background, quietly yet efficiently doing their thing.
Disclaimer
In line with the Trust Project guidelines, please note that the information provided on this page is not intended to be and should not be interpreted as legal, tax, investment, financial, or any other form of advice. It is important to only invest what you can afford to lose and to seek independent financial advice if you have any doubts. For further information, we suggest referring to the terms and conditions as well as the help and support pages provided by the issuer or advertiser. MetaversePost is committed to accurate, unbiased reporting, but market conditions are subject to change without notice.
About The Author
Alisa, a dedicated journalist at the MPost, specializes in cryptocurrency, zero-knowledge proofs, investments, and the expansive realm of Web3. With a keen eye for emerging trends and technologies, she delivers comprehensive coverage to inform and engage readers in the ever-evolving landscape of digital finance.
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Alisa, a dedicated journalist at the MPost, specializes in cryptocurrency, zero-knowledge proofs, investments, and the expansive realm of Web3. With a keen eye for emerging trends and technologies, she delivers comprehensive coverage to inform and engage readers in the ever-evolving landscape of digital finance.
