4 | What is market making?

Market making brings buyers and sellers together to create a marketplace for financial assets such as cryptocurrencies and tokens. Market makers are typically high-volume investors that “create a market” by quoting to buy and sell an asset simultaneously in order to profit on the spread between bid (buy) and ask (sell) prices. They provide crucial liquidity services to the  market ensuring that they are readily available to buy or sell an asset themselves if there is no natural buyer or seller at the time of the market order. These liquidity services benefit all stakeholders by reducing price volatility and supporting fair prices.

Liquidity is dependent on order books — the list of active buy and sell orders for a particular asset or trading pair (e.g. the BTC/USDT pair or the CHER/BNB pair). The difference between the highest bid price and the lowest sell price is known as the bid-ask spread. Markets with low liquidity will typically have a wide bid-ask spread which is often indicative of low volume. On the other hand, markets with high liquidity will have a tighter bid-ask spread and higher volume. Market makers actively facilitate liquid markets by posting tighter spreads between the highest bid and lowest ask prices.

Automated market makers (AMMs) in crypto

Automated market makers (AMMs) have become increasingly popular on decentralized cryptocurrency exchanges (DEXs) in recent years. On these blockchain-based trading platforms, order books are replaced by liquidity pools that are typically comprised of two different cryptocurrencies. AMMs will quote the price between the two cryptocurrencies or tokens simultaneously. Any DEX user can become a market maker by simply providing liquidity to a liquidity pool. These ‘liquidity providers’ (LPs) earn passive income on their deposits for providing liquidity for the pair.

Each DEX protocol integrates AMMs differently. For example, Uniswap employs the Constant Product Market Maker (x * y = k), where x represents the amount of one token in the liquidity pool and y represents the other. In the formula, k represents a fixed constant, which means that the pool’s total liquidity always stays the same. Other protocols may offer different variations such as 80/20 pools (i.e. asset A is maintained at 80% to asset B’s 20% of the pool) or some other means to support fair prices and maintain a healthy market.

Now that we have explored the types of cryptocurrency exchanges and are able to assess their liquidity, let us turn our attention to the dynamics of actually buying and selling crypto through spot and futures markets.
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