The level of liquidity is one of the key factors to assess when making trading decisions in order to buy or sell a specific asset at the market price with minimum delays and losses. Thus, a high level of liquidity provision is one of the most important features an exchanges must offer, and this is when market makers enter the scene.
Who are market makers?
A market maker, or liquidity provider, is a company (banks, brokerage firms) or an individual who quotes both a bid and ask price for financial instrument (stocks, currencies, crypto, futures etc.) and profits on the bid-ask spread, also called turn. According to the SEC, a market maker is a firm that stands ready to buy and sell stock on a regular and continuous basis at a publicly quoted price. Market making strategy implies that the market maker earns on the difference at which he buys or sells an asset. This difference is referred to as the bid-ask or market maker spread.
What is market making in trading?
So, in trading, market making is the activity whereby market makers continuously provide liquidity to takers – both those who want to buy and sell and “take” liquidity from the order book. For options, ETF and futures, the market making strategy is fundamentally the same, the difference is only in the asset that the market maker provides liquidity for. Market makers increase the efficiency of financial markets as they assist fair price discovery and allow minimal disparity in price between different exchanges. On low-liquidity markets, the bid-ask spread is usually wide because of the lack of market makers. On the other hand, markets with many market makers tend to have much tighter spreads. The spread can be accessed in the order book of the exchange.
Another factor determining liquidity is Depth of the Market, or DOM. It defines how much of an asset can be purchased at any given price level. Let’s consider the example of an XBTUSD contract liquidity traded on Xena Exchange. As of writing this document, the spread equates to 0.02%, with the sell price equal to 8299.8 (volume – 26,772 USD) and the buy price – 8300.8 (volume – 80,000 USD). This allows for executing large volume orders at the market price with minimum losses.
To sum up, the key advantages of market making include:
- high liquidity level;
- tight spreads;
- high order book volumes.
In essence, the market maker controls how many units (of stock, cryptocurrency, etc.) are available in the marketplace and adjusts the price based on the supply and demand of said asset. This means that market makers are both useful and influential.
Bitcoin and cryptocurrency market making
When it comes to the cryptocurrency market, the role of market making is crucial. Many tokens lack liquidity and therefore are traded in low volumes. Traders in this case can easily manipulate their prices through pumping and dumping. Furthermore, many investors are not able to open a large position in certain assets without any losses or delays. This affects the whole market and results in overall market inefficiency. Because market makers encourage order book volumes they can indirectly affect trading volumes on an exchange: the larger volume you have in the order book, the more active traders become. Reliable market makers for bitcoin and on certain cryptocurrency exchanges encourage fair price discovery as well as order fulfillment.
Simple market making strategies
Market making is hardly an easy task and the barrier to entry here is high. So, how can you become a market maker? Market makers require a depth of experience and knowledge in portfolio and risk management, brokerage and trading. A bachelor’s degree is typically required and an MBA in Finance is usually a big advantage. Market makers need to manage large capital and usually use automated and HFT strategies. So some basic skills in programming are required. On traditional markets there are usually up to ten ‘designated’ market makers (DMMs), and several hundreds for smaller markets.
Automated market making strategies are widely used in this field as market prices need to be constantly revised. Such strategies are also referred to as execution strategies or sell-side methods as they are designed to extract profits from spreads.One market-making strategy involves the simultaneous placement of buy and sell orders. This strategy carries a risk of failure, on one or two orders, if the price goes in the opposite direction of the working order direction. In order to reduce risk, one should use a neutral average price that will depend on the quantity of the market maker’s open position.To access the performance of trading strategies there are also trading stimulators. The principal constituent of the simulator consists of market order dynamics, particularly because market makers use only limit orders which are matched and filled by market orders. Given this model, traders can simulate order executions and run their market making strategy. For simplicity, the following assumptions are usually made:
- No latency
- No price impact
- No competition with other market makers.
Generally, there are no signals for market makers. The goal here is not to forecast the price, but to rapidly react on to changes.
HFT market making strategies
Put simply, HFT is a type of algorithmic trading associated with high speed, high turnover rates, and short portfolio holding periods. HFT traders use powerful computers to execute dozens of orders within milliseconds, which provide an immense advantage to traders, including market makers.
HFT market maker strategies are required to establish a quote (the most recent price at which some amount of the asset was transacted) and to update it continuously.To sum up, a market maker’s job can be technically difficult, but they add real value to the market and to exchanges. First of all, the market maker must commit to quoting prices in fluctuating markets at which they will buy and sell assets. Then, the market maker must also quote the volume in which they're willing to trade, and the duration of which it will quote the Best Bid and Best Ask prices. Market makers must stick to these parameters at all times, during all market outlooks. When markets become erratic or volatile, market makers must remain disciplined in order to continue facilitating smooth transactions.