Fundamentals: What is market making?
A brief introduction to the essential role of market making in crypto.
In a centralized financial market, market making is the process of both buying and selling assets in order to provide liquidity to traders and reduce the differences in the asking and selling prices of a given asset. In traditional finance, market makers are usually large financial institutions that serve as intermediaries between the buyers and sellers on an exchange. They do so by acting as “makers” and “takers,” on trades, meaning that they are continuously placing and filling buy and sell orders on the exchange.
What is a maker and a taker?
The terms maker and taker refer to the two sides of a trade in a traditional market that relies on order book filling.
- When the “maker” places an order to buy or sell an asset, that order is added to the exchange’s order book.
- And when a “taker” places an order to buy or sell an asset, they’re filling an order that has already been placed on the order book.
Market making in TradFi vs. DeFi.
In traditional finance, market makers are a key source of liquidity for exchanges because of their role as both makers and takers. For example, a market maker could place a buy order for a stock at $100 per share, while also placing a sell order at $100.05 per share. These orders, which are usually placed at a high frequency, essentially create a liquid market for that stock, because other traders can now buy or sell shares in that asset at $100 or $100.05 per share. As large intermediaries, market makers play an outsize role in maintaining stability in traditional financial markets because their scale allows them to reduce volatility.
In DeFi, market making operates differently, since on most decentralized exchanges market making is handled by blockchain-based algorithms called automatic market makers, instead of by institutions. “Makers,” in this context, are the providers of liquidity, and “takers” are those consuming it. Rather than constantly placing and filling buy or sell orders, prices on automatic market makers are controlled by a formula that is constantly adjusting prices based on supply and demand. Since market making on decentralized exchanges is controlled by smart contracts, this reduces risks associated with any single market maker while also making it more difficult for a single party to manipulate the market for an asset.
Why market making is important in crypto.
Automated market makers (AMMs) also allow decentralized exchanges to operate more efficiently and without human intervention. Prior to AMMs, finding consistent liquidity was a major issue for DeFi protocols. Using liquidity pools, though, AMMs help decentralized exchanges automatically source the liquidity for their trading pairs, which is essential to ensuring efficient trading. This helps ensure that the bid-ask spread on assets remains low, since the algorithms that keep prices stable are constantly adjusting based on supply and demand. With liquidity that is sourced directly from other traders and algorithms that execute trades, automatic market makers enable the automatic, decentralized, permissionless buying and selling of assets without intermediaries, one of the core promises of crypto.
Since market making in crypto is based on smart contracts, they also enable wider access to crypto and ensure sufficient decentralization. All anybody needs to interact with an AMM in crypto is a self-custody wallet and an internet connection, and there’s no need to share information with centralized entities or pay high fees to intermediaries. The low fees that do get paid are in-part distributed to the traders who supplied tokens to the liquidity pool as a reward.