What is Market Making?
Market making is the act of simultaneously creating buy and sell orders for an asset in a market. By doing so, a market maker acts as a liquidity provider, facilitating other market participants to trade by giving them the ability to fill the market maker's orders. Traditionally, market making industry has been dominated by highly technical quantitative hedge funds and trading firms that have the infrastructure and intelligence to deploy sophisticated algorithms at scale.
Market makers play an important role in providing liquidity to financial markets, especially in the highly fragmented cryptocurrency industry. While large professional market makers fight over the most actively traded pairs on the highest volume exchanges, there exists a massive long tail of smaller markets that also need liquidity: tokens outside the top 10, smaller exchanges, decentralized exchanges, and new blockchains.
In addition, the prohibitively high payment demanded by pro market makers, coupled with a lack of transparency and industry standards, creates perverse incentives for certain bad players to act maliciously via wash trading and market manipulation. For more discussion on the liquidity problem, please check out this blog post.
How does market making work?
WARNING: Not financial or investment advice. Below are descriptions of some risks associated with the pure market making strategy. There may be additional risks not described below.
Market-making strategies work best when you have a relatively calm market but with sufficient trading activity. What that means for pure market makers is, he would be able to get both of his bid and ask offers traded regularly; the price of his inventory doesn't change by a lot, so there's no risk of him ending up on the wrong side of a trend. Thus he would be able to repeatedly capture small profits via the bid/ask spread over time.
In the figure above, the period between 25 Feb and 12 Mar would be an example of the ideal case. The asset's price stayed within a relatively small range, and there was sufficient trading activity for a market maker's offers to be taken regularly.
The only thing a market maker needs to worry about in this scenario is he must make sure the trading spread he sets is larger than the trading fees given to the exchange.
Low trading activity
Markets with low trading activity higher risk for pure market-making strategies. Here's an example:
There's a risk in any market with a low trading activity where the market maker may need to hold onto inventory for a long time without a chance to trade it back. During that time, the traded assets' prices may rise or drop dramatically despite seeing no or little trading activity on the exchange; this exposes the market maker to inventory risk, even after mitigating some of this risk by using wider bid spreads.
Other strategies may be more suitable from a risk perspective in this type of market, e.g., cross-exchange market making.
Market/inventory risk due to low volatile or trending markets
Another common risk that market makers need to be aware of is trending markets. Here's one example:
Suppose a pure market maker sets his spreads naively in such a market, e.g., equidistant bid/ask spread. In that case, there's a risk of the market maker's bid consistently being filled as prices trend down, while at the same time, the market continues to move away from the market maker's ask, decreasing the probability of sells, this would result in an accumulation of inventory at precisely the time where this would reduce inventory value, which is "wrong-way" risk.
However, it is still possible to improve the probability of generating profits in this kind of market by skewing bid-asks, i.e., setting a wider bid spread (e.g., -4%) than ask spread (e.g., +0.5%). In this way, the market maker is trying to catch price spikes in the direction of the trend and buy additional inventory only in the event of a larger move, but sell more quickly when there is an opportunity. So to minimize the duration, the inventory is held. This approach also has a mean reversion bias, i.e., buy only when there is a larger move downwards, in the hopes of stabilization or recovery after such a large move.
Market making in volatile or trending markets is more advanced and risky for new traders. It is recommended that a trader looking to market make in this kind of environment to get mentally familiar with it (e.g., via paper trading) before committing meaningful capital to the strategy.