Market Making Stuff Up

Level 3 - Virgin DeFi Analyst

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Today’s post is about market makers, their sometimes dubious nature, and how to spot market manipulation.

Have you ever seen a coin, perhaps of the meme variety, that keeps going up and you can’t figure out who the heck is buying it?

There just might be a market maker involved!

Iggy Azalea, the celeb that launched the token $MOTHER, has engaged not one but two market makers. More providers, more liquidity. Read on to learn about how the opaque world of crypto market making works (hint: there is no such thing as a free lunch).

What is a Market Maker?

A market maker deploys infrastructure, expertise and sometimes its own capital to provide a service: pricing markets efficiently and providing liquidity.

Market making is quoting a two-way market, providing liquidity to other market participants

A two way market means being willing to either buy or sell the token. This means a market maker will maintain bid and offer prices which other participants can trade on. Providing liquidity means making an two-sided inventory (token and USD) available to fulfill orders in the marketplace.

Without a market maker, traders will need to rely on coincidence of wants - waiting for another trader to sell tokens when they want to buy, and vice versa. This leads to trading delays and high transaction costs.

Transaction costs would be high because the market is not efficiently priced. The owner of a token is biased to believe in a higher valuation, even when selling the asset. This is due to the endowment effect and other cognitive biases. A buyer may also be cautious about overpaying for an asset.

This could lead to a market where a token owner wants to sell for no less than $5.00 and a the most eager buyer will only offer $4.50. This implies a 10% cost to trade the asset, a significant headwind. High trading costs deter investors and speculators, whereas low trading costs encourage more frequent trading activity.

Why Do Projects Hire A Market Maker?

Hiring a market maker will result in tighter spreads and higher displayed liquidity, whether on CEX or on DEX, giving investors additional confidence to buy the token. Market makers also offer additional services, including strategy for obtaining the coveted token listing on centralized exchanges.

CEX are responsible for the user experience of their customers and will be reluctant to list illiquid and therefore excessively volatile tokens. CEX are in business to make money from fees; a token supported by a reputable market making firm is likely to generate far greater volume and therefore revenue for the exchange.

Protocols can choose between two models when hiring a market maker:

• agency model

• proprietary model

In the agency model, the protocol provides all the capital (two-sided inventory, both their native token and USDC). They pay the market maker a monthly fee in USD for the use of their infrastructure and skills, but the project is responsible for any profits and losses incurred in market making activities. Commonly the market maker is entitled to a performance fee representing some percentage of any profits earned.

The agency model gives the protocol the most control. They can dictate the KPIs:

• uptime: market makers are contractually obliged to have quotes in the market for a high percentage of time, e.g. 99% of the time 24 hours a day 365 days a year in crypto. The remainder of the time they may be conducting maintenance of their infrastructure or removing their quotes to manage risk in highly volatile times.

• spread %: market makers agree to provide a minimum spread for the token, for example 0.5% - this ensures that investors can always transact without incurring too much slippage. The market maker may choose to quote a tighter spread in profitable conditions to take more market share (market making is competitive).

• depth: it’s not useful to quote a tight spread in a size which is too small for average deal sizes, so market making contracts specify how much inventory - tokens or dollars - must be available at certain distances from the market price

This model is most attractive to protocols who can afford to provide two sided inventory. Most protocols in the bootstrapping stage lack sufficient USD.

In the proprietary model, the market maker provides its own capital at its own risk and therefore has a greater influence on the deal terms and KPIs. The project will provide a loan of a significant share of tokens, typically at least 5% of supply. And the project will grant the market maker options over the tokens.

This optionality allows the market maker to elect to either repay the loan in tokens, or substitute a pre-agreed sum in USD (strike price). These agreements are long term, e.g. 1 year or more. During this time the token price could have changed significantly.

If the token price has soared, the market maker will repay USD and profit from any tokens still held in inventory.

If the project is a flop, the market maker will return the borrowed tokens.

How Do Market Makers Profit?

Market making is not necessarily a profitable activity on newer tokens and so the firm will be looking to make the bulk of its profit on the optionality in a proprietary agreement, or the fees in an agency agreement.

Proprietary KPIs should be drafted loosely enough that the market maker can limit its exposure to tokens which fail. If prices decline, the firm will reduce the size of its USD bids and skew them towards lower prices, while trying to sell any accumulated inventory as quickly as possible to any willing buyer.

A large token loan leads to the market maker controlling a high percentage of the circulating supply at launch. This typically allows the firm to both satisfy initial investor demand, and as a consequence put an initial cap on price. The market marker can therefore start by “selling high” with borrowed tokens.

Later, as investors sell to take profit (or losses) and the price declines, the market maker can re-accumulate their token inventory, without being exposed to the risk of the token price declining further (as they aim to purchase only sufficient tokens to repay the loan). In some cases the firm will need to spend USD to fill additional sell orders from investors, but they’ll try to manage their risk.

If at the expiry of the agreement the firm finds itself without sufficient tokens to repay the loan, it will exercise the option to acquire the tokens below market price locking in a profit. The firm therefore faces no risk if investor demand is unexpectedly strong, leading to depletion of their token inventory.

Memecoin Market Makers

There has been a rise of market maker involvement in memecoins. These market makers sell the prospect of “painting a chart”, getting listings via trading volume and getting a coin to higher valuations for a time. These deals can be sometimes be quite predatory, and resemble hedge fund performance structures. As mentioned in the agency model, the market maker might take a fixed retainer, a portion of all tokens sold, a portion of profit on market making activity, and require the team to put up the inventory, all at once. The market maker in this case is essentially acting as a hedge fund that trades in client accounts instead of pooling the funds.

Why is this an issue? For one, the market maker is simply providing a service. They have no skin in the game for long-term success of a project. And. Making money as a market maker in the small cap market is hard. It’s highly likely their retainer is their profit center, and they do not have any edge when it comes to putting on actual risk.

If you’re interested in diving deep on portfolio and risk management and learning more about the attention markets that drive the crypto market, check out the Academy.

Summary

• projects engage market makers to:

  • improve their odds of listing on a CEX

  • make their token more attractive to investors

  • provide expertise and consulting e.g. tokenomics design, help with fundraising

• deals are negotiated based on who is providing the capital and taking the risk

• market making isn’t always profitable; the firm seeks to control risk while profiting from either fees or options

• in a loan + option deal, the firm can sell short without risk (which gives it capacity to buy tokens without risk)

As a trader, user, or protocol founder, you need to be aware of situations where there are predatory market makers looking to create exit liquidity.

How To Spot Possible Market Manipulation

If you’re not familiar with how derivative markets work in crypto, read our introductory piece.

• Volume: absolute and proportional to market cap - if a $50mm market cap token which nobody really traded goes from $1mm average daily volume to half a billion (including derivatives) there’s obviously something afoot. For larger cap tokens, volume is also relevant. A > $1b market cap coin turning over its entire market cap in a day is usually a sign of a top (e.g. PEPE this year)

• Open Interest: similarly, if the derivatives open interest is a large percentage of the market cap (or in these absurd times, more than the market cap), that’s an indication that the derivatives market isn’t just being used for bona fide purposes like hedging, or for some small time gamblers to take on a few thousand dollars in leverage

• Basis: Basis refers to the difference between the prices of the spot market and the futures / perpetual contracts. Arbitrageurs usually keep these prices in line. If spot is trading at a large premium to futures, this suggests that spot isn’t available (cornered, not borrowable, or spot deposit/withdrawal is temporarily disabled on exchanges). If spot was available, traders would go long the derivatives and short the spot to profit from the difference as the basis should converge to zero in the long term. We’ve seen spot trade at 20-30% premiums to derivatives in manipulated coins recently.

• Funding Rates: As perpetual swaps don’t have a settlement, traders are incentivized to keep prices in line by making trades which move the price closer to fair value (spot price). This incentive takes the form of a periodic funding payment. If funding is at unrealistic levels when annualized (e.g. thousands of percent APY), there is likely manipulation afoot. Thinking rationally, nobody would pay 2,700% funding rate to short an asset for the long term; and nobody would invest in an asset with a 2,700% yield (not sustainable; likely value zero).

If you’re not familiar with altcoin derivatives it will take time and study to familiarize yourself with what are “normal” levels of volume, open interest, and basis/funding and which suggest manipulation.

So you’ve spotted a possibly manipulated coin. Now what?

Actions

1. Sell your existing holdings at a good price

2. Buy in anticipation of a pump

3. Do nothing

If you already own a coin which is being manipulated up, you have an opportunity to sell at a likely overly high valuation. If you believe in the coin fundamentally and want to hold for the long term, there’s even a risk free way to lower your cost basis:

• sell your spot holding when spot is premium to perps; and

• buy the equivalent value in perps; then

• collect funding until futures and spot come back in line

• close your perps and re-buy your spot

Otherwise you might just want to exit your position completely and dollar cost average back to your desired holding over weeks-months after valuations return to a more realistic level.

Buying in anticipation of a pump is more risky - you need to know the coin and have a good reason to believe you’re early. Pumps are generally short lived so you’ll want to cut most of your position when you’re quickly in profit.

Interested in this topic but found this explanation too technical? Check out this Level 1 NGMI simplified explanation of market makers: Fruit Vendors and Market Makers

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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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