How Do Crypto Market Makers Hedge: Popular Strategies

Crypto market making is essential for digital asset trading as it provides liquidity to cryptocurrency exchanges. Nevertheless, operating as a crypto market maker requires applying active trading strategies, thus exposing it to various risks related to the market performance and inventory. This is why hedging is an indispensable element of digital asset market making activities.

In this article, we explore what hedging means in the context of crypto trading, why it is important for risk management, and the strategies that crypto market making services use to remain profitable and solvent in such a volatile market environment.

What Is Hedging and Why Is It Important in Crypto Market Making?

Hedging is a risk management strategy in which a market participant takes positions to offset potential losses from their primary holdings. In the context of cryptocurrency market making, hedging involves opening counterbalancing positions to protect inventory from sudden price swings.

For crypto market makers who buy and sell tokens on exchanges regularly, hedging is essential. Without it, market making of digital assets would be vulnerable to the full force of price volatility and could incur losses as a result of directional market movements.

Employing hedging can ensure that their profits originate from bid-ask spreads rather than speculation on shifts in crypto token prices.

Now, let us explain what inventory risk entails and why it is a critical challenge even for the biggest crypto market makers such as DWF Labs.

What Is Inventory Risk in Crypto Market Making?

Inventory risk arises because market makers need to hold cryptocurrency assets for trading and liquidity provisioning. If the market moves in only one direction, market makers face the risk of losing value in an unbalanced position. For instance, if a crypto market maker accumulates a sizeable long position during a price decline, the market maker runs the risk of incurring substantial losses on that inventory.

However, exposure to these price fluctuations can be reduced by trading across exchanges or offsetting positions in derivatives markets. This allows them to focus on trading fees and spreads, which is the core principle of market making in crypto.

Below we have listed the most popular hedging strategies in the cryptocurrency markets.

Common Hedging Strategies for Crypto Market Makers

Managing risk exposure is a key part of crypto market making services because it helps the market stay stable and its participants to make money. To protect themselves from various risks, crypto market makers use different hedging strategies, specifically targeting the risks of holding inventory while quoting buy and sell prices. These methods are designed to quote buy and sell prices while managing the risk of holding volatile inventory.

Let’s dive deeper into the most common hedging strategies in crypto market making to uncover how they work in practice.

1. Delta-Neutral (Delta Hedging)

Delta hedging means maintaining a balanced position so that the market maker’s entire crypto portfolio has minimum directional exposure (delta ≈ 0). In practice, this often means that, if a market maker accumulates a long position on a token, an offsetting short position—for example, via futures or perpetual swaps—will be taken to neutralise price risk. The goal is to make the portfolio delta-neutral, which means that its value stays approximately the same regardless of how the price moves.

This strategy enables a crypto market maker to profit from bid-ask spreads and trading fees without being overly exposed to the asset’s price trend. For instance, a market maker who has provided liquidity by holding 100 BTC might short approximately 100 BTC worth of Bitcoin futures. If the price goes down, the short position will make up for any loss on the inventory, and vice versa.

2. Hedging with Crypto Options or Futures

Many crypto market makers use derivatives such as crypto options and perpetual futures to protect their investments; in other words, to hedge. Futures and perpetual hedging are straightforward: if a market maker holds a long position for a certain token in the spot market, it can short the same amount in the futures market to lock in a price and protect itself from losing money. This is a common way for a crypto market maker to hedge inventory on crypto exchanges, especially since many well-known tokens also have developed futures markets.

At the same time, crypto options trading gives market makers and institutional players another way to protect themselves from big price changes. For example, a market maker might buy put options to protect against a big decline in the price of a coin where they hold a large inventory.

How do crypto options work? They give the ability to sell an asset at a predetermined price, capping losses if the token’s price goes down. On the other hand, market makers can hedge short positions using call options or other option structures. The ongoing growth of the crypto option market throughout 2024 has expanded the toolset for risk management, allowing market makers to hedge with greater nuance in volatile markets. By combining spot positions with futures and options, crypto market makers retain delta-neutral position and lower volatility.

3. Cross-Exchange Hedging

The spread of crypto markets across multiple trading platforms makes cross-exchange hedging crucial. This technique is also known as exchange arbitrage or liquidity mirroring. This involves trading on different exchanges to distribute risk more effectively.

For instance, if a crypto market maker provides liquidity on a smaller or less liquid exchange (the ‘maker’ exchange) and an order is filled—for example, buying 1,000 tokens—they immediately sell the same amount on a more liquid exchange (the ‘taker’ exchange) at the market price. This type of trading hedges the position right away, neutralising inventory accumulation. If done correctly, the market maker makes a small spread on the less liquid venue while removing directional risk on the liquid venue.

Cross-exchange hedging also makes the crypto market deeper overall: by maintaining positions across trading platforms, market makers enhance liquidity and achieve better price discovery for traders. However, this strategy requires advanced bot software for automated trading, because the trading algorithm has to execute the hedge on the second exchange the moment an order is filled on the first.

4. Dynamic Inventory Management

In addition to external hedging instruments, crypto market makers usually manage inventory risk by dynamically adjusting their bid and ask price quotes in what is called Dynamic Inventory Management.

If the inventory becomes unbalanced, a market maker modifies its quotes to encourage trading in the direction that will rebalance it. For example, if a market maker is long on a token, it might increase its sell quotes to reduce exposure. This internal balancing complements other hedging strategies to ensure market stability.

To summarise, the following table outlines how described hedging strategies are used in crypto market making:

Challenges in Implementing Hedging Strategies

Implementing effective hedging is not always simple. When trading cryptocurrencies, speed of execution is critical, as market conditions can shift in a matter of seconds. To execute trades in multiple markets almost instantly, market makers require advanced trading algorithms and infrastructure capable of such rapid execution.

Another challenge is the fragmentation of liquidity across centralised and decentralised platforms. Market makers need sophisticated systems for comprehensive position tracking and management in order to maintain a clear picture of their exposure and inventory.

Transaction costs and liquidity restrictions are also significant factors. Frequent hedging trading incurs fees, and some derivative markets may lack the liquidity required to carry out hedging trades without slippage.

To overcome challenges, market makers can rely on:

• Quick trading bots that instantly execute hedges.
• Real-time risk monitoring systems for continuous oversight.
• Low-latency infrastructure for efficient exchange connectivity.
• Analytics tools for assessing market conditions and exposure.

Both strategy and technology are essential for effective hedging in the crypto exchange market. There are many challenges, but with the right systems and a focus on risk management, a market maker can dynamically stay ahead of the risk without compromising liquidity quality.

Final Thoughts

For anyone seeking to understand how crypto market makers work and how they influence the digital asset market, understanding hedging is essential. It allows market makers to mitigate inventory risk, maintain profitability, and support price stability across exchanges.

Trading platforms and blockchain projects that consider working with a crypto market maker should prioritise those who demonstrate effective risk management practices, including hedging: such firms are more likely to be better at creating and maintaining healthier and stronger trading activity.