One of the best known but least understood crypto forces is the market maker. Relied on by project teams, exchanges, and project founders to provide liquidity and support swaps, market makers (MMs) are a net good for the industry, even if they occasionally get a bad rep from those who misunderstand the role they play.
At their core, MMs exist to provide liquidity on the buy and sell side, enabling traders to acquire or dispose of tokens on demand, even for crypto assets with a low market cap, volume, and liquidity. Without market makers on hand to provide a liquidity buffer, selling small cap tokens would incur significant slippage. This article will examine the way in which MMs work to make the market more attractive to buyers and sellers alike.
What is a market maker?
A market maker is an entity – typically a company – that uses assets it holds to provide liquidity to certain financial markets. For this reason they’re also sometimes known as liquidity providers (LPs). If you’ve ever provided liquidity to a decentralized exchange (DEX) such as Uniswap, you’ll have direct LP experience. Market makers do that on a much larger scale, usually for centralized exchanges but sometimes for DEXs too.
Market makers work by setting a series of limit orders at different price points, known as the ‘buy’ and ‘ask’ prices. They will set orders for both assets on both sides of the trade e.g. BTC and ETH. This ensures that both buy and sell orders can be executed. Otherwise, a trader would need to wait for a willing counterparty to come online and agree to sell to them at their desired price level.
A market maker will typically set reference prices for crypto assets based on the price they are trading for on other exchanges. This ensures price consistency and reduces price dislocation, which leads to arbitrage. Essentially, MMs ensure that on the exchange or platform in question, a trader can reasonably expect to get a similar deal to that they would receive on any other comparable platform.
Market making in action
One of the industry’s best known market makers is DWF Labs. The venture capital firm and market maker provides liquidity for numerous crypto projects. It has a presence on 40 exchanges and covers approximately 800 trading pairs. For the projects that utilize its services, DWF Labs provides market making on demand, allowing them to tap into deep pools of liquidity, driving up native token trading volumes. One misconception surrounding MMs is the notion that they drive price discovery. That’s not their prerogative. In fact, market makers can act as a dampener on unscrupulous trading activity executed by third parties such as pump and dumps. In such schemes, traders will take advantage of low liquidity to dramatically pump up the price of a token, duping unwitting traders to FOMO in before early buyers then dump their tokens, crashing the market. The more liquid the market, through MM involvement, the harder it is to manipulate.