Market makers play a key role in the attractiveness of an exchange for external traders. Their primary task is to ensure important trading metrics, such as buy and sell orders with minimal spread and order book depth.
Essentially, market makers create most of the market activity that external traders can utilize. In this article, we will explore the essence of their work, their strategies, and the benefits for both market makers and exchanges.
When discussing exchange liquidity, the main evaluation criterion is the spread of trading tokens. The spread is the difference between the highest price buyers are willing to pay for an asset and the lowest price sellers are willing to accept. The spread size indicates user interest in the asset. However, in highly volatile markets, the spread width can fluctuate chaotically due to sudden price changes. To mitigate this, exchanges turn to market makers. Their main tasks include:
- Minimizing the spread and continuously placing orders for buying and selling
- Filling the order book with orders, creating additional liquidity and market depth
- Protection against sudden “flash crashes” in the price.
For the fulfillment of these tasks, external institutional clients are usually hired, who can provide both software for automated bots and their own liquidity.
Market maker benefits
If the benefits of having market makers on the markets are clear – attractiveness for users and order book depth are undoubtedly positive aspects, the question arises: how do they themselves earn?
The first and foremost point is that such services are not provided for free. In most cases, the exchange shares a significant portion of the commission from “live” client trades with market makers. Thus, market makers profit in the form of commission or fixed payment for services as stipulated in the agreement with the exchange.
The second point is that by simultaneously creating buy and sell orders (thus providing liquidity), when both orders are executed, the market maker trader earns a profit equal to the size of the spread itself. Risks in this aspect may lie in the strategy of providing liquidity – in the event of a sharp change in price, the trader risks being left with a significant amount of purchased assets without the ability to sell them with reverse orders.
Another way for market makers to profit is through arbitrage operations. In general, a significant portion of such trading bots use the arbitrage principle when forming orders by comparing the current market rate with that of larger players. For the fastest order formation and cancellation when prices change, market makers often require specific conditions from exchanges, such as so-called “colocation” – the ability to have the fastest access to exchange servers, thus gaining an advantage over other market participants.
Besides market makers, it’s also necessary to mention another market participant – liquidity providers, who, nevertheless, prefer to work by forming spreads. Every exchange is interested in them as they are the ones who shape the depth of the order book with their orders. Generally, due to this, the terms for commission rates for “maker” transactions are always significantly lower than those for “taker” transactions.
All that we’ve discussed so far applies exclusively to centralized exchanges (CEX). Decentralized exchanges (DEX) use a different type called Automated Market Maker (AMM). Its essence lies in mathematically calculating the current asset price and attracting liquidity pools to execute orders.
Therefore, the main goals that a market maker should achieve are reducing and maintaining a narrow spread, providing order book depth, and ensuring smooth price movements. In exchange for fulfilling these tasks, exchanges are willing to share commissions and pay for the work of market makers who essentially make the market comfortable for traders.
There’s no single strategy that market makers operate on – it could be arbitrage-type order creation, or a modified Dollar Cost Averaging (DCA) type adapted to current requirements, like the strategy we’ve adapted in our trading product, Burvix Traders, specifically for market-making tasks. We already have an active case of its implementation to create liquidity and spread on the exchange.
Additionally, there are many offerings of automated bots in the market for ordinary users who can even try their hand at market making with a small amount and understand the process from within.