The only article you will ever need to understand market makers.
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Imagine you're at a busy fruit market.
There's a vendor in the middle who always has apples, no matter when you visit.
This vendor makes sure that there's never a shortage of apples and that prices don't skyrocket when they're scarce.
Everyone knows that regardless of whether it's raining, whether there's a big apple festival, or even if there's a sudden surge in demand for apple pies, this vendor is your go-to person for apples.
After hearing stories of this vendor, you become curious about how he pulls this off and decide to seek him out.
After a long journey to Apple Street, you finally ask the man behind the booth how he does it.
The vendor explains that his job is to make sure he is always available to buy and sell apples. If you’re in the market for apples, you can come to him and trade without waiting too long. Otherwise, there might be days you can’t find apples!
Since the vendor always has apples, he doesn’t jack up prices when apples are scarce or drop them too low when there are lots of apples. Instead, he aims to keep a relatively stable price by always being ready to buy or sell. The vendor prevents wild swings and keeps things predictable.
This predictability and reliability gives people confidence. If you need to prepare for a last minute arrival of guests and need a fruit, you know you can head to the vendor for apples. The dragon fruit vendor always seems to be out of stock!
After seeing the vendor’s active and reliable business, other fruit vendors around town began to set up apple stalls, further increasing the market’s size. Over time, the vendor’s solid business inspires other vendors to set up their own stalls.
In essence, the vendor ensures the apple market functions smoothly through constant availability, stable prices, market confidence, and encouraging broad participation.
Inspired by the vendor’s story, you decide you want to be an apple vendor too. Buying from willing sellers, and selling to willing buyers. How hard could it be?
Having seen his share of starry eyed youth, the vendor cautions you to consider the risks.
The vendor always runs the risk of over-purchasing apples from growers and not being able to sell them all in time. This could result in losses, particularly as apples are perishable goods.
If he purchases apples at a certain price and many growers rapidly slash their prices to clear out their stock at the end of the day, he may end up selling at a loss.
Since he buys from various growers, there's a risk of purchasing subpar or defective apples. If he doesn't check every apple he buys, he might unknowingly sell these to customers, affecting his reputation.
If apple vendors start setting up shop in his territory, the competition could impact his sales and profit margins.
Finally, any number of unpredictable events can impact his apple business, ranging from bad weather to petty fights with neighboring towns.
After learning of the nuances involved, you realize that perhaps it isn’t so easy after all. Still, you came all this way. You ask the man one last time, “then how did you pull it off?”
The vendor takes you back to the early days, where he exerted considerable control over the apple market. Back in the day he used to be the primary buyer for most of the apple growers, which allowed him to influence the buying prices. The growers had to adjust their prices based on what he was willing to pay.
With his central position and consistent presence, he was able to influence the perception of apple scarcity or abundance. By adjusting his display and the quantity he puts out for sale, he could create a sense of urgency or abundance.
The vendor was able to influence both the supply and the demand for apples. Recognizing his strength, he could use his influence to set trends in the apple market. By giving fuji apples the prime display area and promoting it, he would influence the preferences of buyers, thereby guiding growers on what to plant for the following season.
The vendor, having become the destination for apples from visitors all over, could now promote certain growers over others. By becoming a significant influencer and stabilizer of the apple market, the vendor was able to mitigate many of the risks that came with the business.
With the sparkle back in your eye, you decide you need to obtain a little more information. You head over a neighboring town with a vendor famous for selling handcrafted pocket watches.
Upon arriving in the town, you see the vendor’s logo plastered all over town. You easily find your way to the location, which rather than being a stall is a large store covered in gold. You see a man inside with a diamond ring.
“You must be the owner” you state.
He takes one look at you dressed like a homeless person and says “go back to the tent.”
Shocked, you decide to leave. Upon leaving the store an elderly gentleman notices the distressed look on your face. He takes you to the side and claims to have knowledge of the store’s inner workings.
You learn that, like the apple vendor, the watch vendor is a buyer and seller of this product. However, his primary focus is on maximizing his profits, regardless of the market’s health.
He would spread rumors about certain pocket watches, artificially driving up their demand, only to sell them at exorbitant prices. Once he'd made a hefty profit, he'd debunk his own rumors, causing the watch’s value to plummet and allowing him to buy them back at a fraction of the cost.
This had worked extremely well, allowing him to become wealthy and influential. Stories of the vendor’s brilliance had spread across the region, as people remained unaware of his manipulation behind the scenes.
“This man is a genius!” you think. The elderly man, noticing the young man in front of him had missed the point, leaves you with a final prediction - that the watch vendor would be out of business in a matter of months. You barely hear him, as you have already begun planning your new business.
You head back to your home town and begin working on your own shop selling handcrafted tokens. These tokens, each unique in design, represented the town's heritage, and people traded them based on their perceived value.
Every day, you would set up your stall, ready to buy any token at a fair price and sell any token to anyone at a slightly higher price. After months of work you had a handful of solid relationships with token traders. Right around then, you begin to hear rumors about a famous vendor who had disappeared. He was famous for his dealings in the pocket watch market.
It turns out that as time went on, the consequences of the watch vendor’s actions began to surface. The pocket watch market became highly unstable. Owners saw their cherished pocket watches swing wildly in value, leading to distrust and apprehension. Watchmakers, unsure of the real value of their watches, hesitated to produce more, leading to a decline in the variety and quality of watches available.
The townsfolk, once impressed by the vendor’s wealth, began to see through his schemes. As trust in the vendor eroded, his influence waned. His past customers became increasingly disgruntled and coalesced into an angry mob. As he felt the mob closing in on him with the authorities soon behind, the man was forced to flee, leaving behind much of his wealth and all of his influence.
The elderly man’s warning had come true. Having been working on getting your operation off the ground, you decide to seek the elderly man out for advice. After weeks of searching, you find him on the beach under a tree, eating an apple.
You press him for advice on how to avoid the watch vendor’s fate. He began to educate you on the importance of a stable and fair market, and having a strong reputation.
Armed with new wisdom and an insatiable desire to succeed, you returned to your town. As days turned into weeks, your reputation grew. People knew that if they ever needed to buy or sell a token, your stall was the place to go. You became the pulse of the town’s token market, much like the apple vendor.
However, the token market was more volatile than the apple market. The value of tokens could change rapidly based on news from the town council, festivals, or even rumors.
You had to be agile, adjusting your buying and selling rates multiple times a day. You kept a keen ear to the ground, always listening for the latest news that might affect token values.
One day, a rumor spread that a particular token, made by an anonymous token maker, was discovered to have a hidden treasure map. News about this token quickly began to spread, almost as if it was in coordination (though you did not know for sure). As part of your business, you had purchased a large quantity of these tokens earlier. You found yourself in a powerful position, with the ability to set the price at a premium to willing buyers.
However, you remembered the lessons from the elderly man.
Instead of exploiting the situation, you set a fair price, ensuring that while you made a profit, the tokens remained accessible to those who genuinely wanted them.
As the days passed, the rumor was debunked. There was no hidden treasure. The value of the token crashed back to its normal price, but your reputation soared. People admired your fairness and integrity. They realized that while you had the power to influence the market, you chose to stabilize it instead.
Epilogue
You’ve figured out by now that the vendors in our story are market makers. We hope you enjoyed this fun and simplified version of how it works. There’s a reason we have been covering this topic at length over the last week (both in simple and technical terms).
The reason will all be made clear in our next post for paid subscribers. If you haven’t signed up already, we suggest you do!
P.S. For the turbo autists - we recognize that in the story there is some slight overlap between what would be done by an exchange vs. a market maker but in crypto they have historically had a very close relationship (even being under common ownership and control).
Until next time!
Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.
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