Article Rewrite:
Title: The Role of Cryptocurrency Market Makers in the Crypto Market
Introduction:
Every day, the myth of getting rich in the crypto market persists. While most participants are not in it for quick gains but for a chance at a turnaround, cryptocurrency market makers stand out as the top predators closest to the money in this dark forest.
Price manipulation, pump and dump schemes, and taking advantage of market inefficiencies are synonymous with cryptocurrency market makers. However, before labeling them with these derogatory terms, it is important to recognize the crucial role they play in the cryptocurrency market, especially for early-stage projects.
In this article, we will explain what market makers are from the perspective of Web3 projects, why we need them, the DWF incident, the main operating models of cryptocurrency market makers, and the existing risks and regulatory issues. We hope this article will be helpful for project development and welcome discussions.
I. What are Market Makers?
CitadelSecurities, a leading global hedge fund, defines market makers as essential players in maintaining market liquidity. They achieve this by simultaneously providing buy and sell quotes, creating a market environment with liquidity, market depth, and the ability for investors to trade at any time, injecting confidence into the market.
Market makers are crucial in traditional financial markets. On Nasdaq, for example, there are an average of about 14 market makers per stock, totaling about 260 market makers in the market. Additionally, in markets with lower liquidity than stocks, such as bonds, commodities, and forex markets, most trades are conducted through market makers.
Cryptocurrency market makers refer to institutions or individuals that provide liquidity and buy and sell quotes for projects in cryptocurrency exchange order books and decentralized trading pools. Their main responsibility is to provide liquidity and market depth for trades in one or more cryptocurrency markets and profit from market fluctuations and supply-demand differentials through algorithms and strategies.
Cryptocurrency market makers not only reduce trading costs and improve trading efficiency but also facilitate the development and promotion of new projects.
II. Why do We Need Market Makers?
The main goal of market making is to ensure sufficient market liquidity, market depth, and stable prices to inject confidence into the market and facilitate trade. This not only lowers the entry barriers for investors but also incentivizes them to engage in real-time trading, which in turn brings more liquidity, creating a virtuous cycle and a safe trading environment for investors.
Market makers are particularly important for early-stage Initial Exchange Offering (IEO) projects because these projects require sufficient liquidity, trading volume, and market depth to maintain market hype/awareness and promote price discovery.
2.1 Providing Liquidity
Liquidity refers to the ease with which assets can be quickly converted into cash without significant price impact and describes the extent to which buyers and sellers in the market can trade relatively easily, quickly, and at low costs. High liquidity markets reduce the costs of any specific transaction and facilitate the formation of trades without causing significant price fluctuations.
Essentially, market makers facilitate faster, larger, and easier buying and selling of tokens for investors at any given time by providing high liquidity without interrupting or affecting operations due to significant price fluctuations.
For example, an investor needs to buy 40 tokens immediately. In a high liquidity market (order book A), they can buy 40 tokens at a price of $100 each immediately. However, in a low liquidity market (order book B), they have two choices: 1) buy 10 tokens at $101.2, buy 5 tokens at $102.6, buy 10 tokens at $103.1, buy 15 tokens at $105.2, with an average price of $103.35; or 2) wait for a longer period of time for the tokens to reach the desired price.
Liquidity is crucial for early-stage IEO projects, as operations in low liquidity markets can affect investor confidence and trading strategies, potentially leading to the demise of the project.
2.2 Providing Market Depth and Stable Token Prices
In the crypto market, most assets have low liquidity and lack market depth, which means even small trades can cause significant price changes.
In the aforementioned scenario, after the investor buys 40 tokens, the next available price in order book B is $105.2, indicating a price fluctuation of approximately 5% from one trade. This is especially true during market volatility, where fewer participants can cause significant price fluctuations.
Market makers provide a large amount of liquidity, creating narrow bid-ask spreads in the order book, which are usually accompanied by solid market depth. This helps stabilize token prices and mitigate price fluctuations.
Market depth refers to the available quantity of buy and sell orders at different price levels in the order book at any given moment. Market depth also measures the ability of an asset to absorb large orders without significant price changes.
Market makers bridge this supply-demand gap by providing liquidity, playing a critical role in the market. Imagine which market you would prefer to trade in:
Market Maker Roles:
1) Providing ample liquidity
2) Providing market depth to stabilize token prices, ultimately enhancing investor confidence, as every investor wants to buy and sell their assets in real-time at the lowest trading cost.
III. Major Players in Cryptocurrency Market Making
Market making can be considered one of the top businesses in the food chain, as market makers control the fate of project tokens after they are listed. Market makers often collaborate with exchanges, easily forming a monopoly, with a few large market makers dominating market liquidity.
In July 2023, Worldcoin, a cryptocurrency project jointly created by OpenAI’s Sam Altman, reached agreements with five market makers for liquidity provision upon its official launch. These five market makers collectively lent 100 million $WLD tokens for liquidity provision and were required to return the borrowed tokens or buy them at a price ranging from $2 to $3.12 per token after three months.
The five market makers are:
A. Wintermute: A UK-based company with notable investments in projects such as $WLD, $OP, $PYTH, $DYDX, $ENA, $CFG, and more. It has invested in over 100 projects since 2020.
B. Amber Group: Established in 2017, a Hong Kong-based company with a board of directors that includes well-known Chinese institutions like Distributed Capital. The team consists mostly of Chinese members. Involved in projects like $ZKM, $MERL, $IO, and more.
C. FlowTraders: Founded in the Netherlands in 2004, FlowTraders is a global digital liquidity provider specializing in exchange-traded products (ETP). It is one of the largest ETF trading companies in the EU and has created exchange-traded notes (ETN) based on Bitcoin and Ethereum, conducting cryptocurrency ETN trading.
D. Auros Global: Linked to FTX, Auros Global filed for bankruptcy protection in the British Virgin Islands in connection with FTX, with $20 million in assets stuck on FTX. News of a successful restructuring has recently emerged.
E. GSR Markets: Founded in 2013 in the UK, GSR Markets is a global cryptocurrency market maker specializing in providing liquidity, risk management strategies, programmatic execution, and structured products to mature global investors in the digital asset industry.
IV. The DWF Scandal
DWF Labs, a “social media-famous” market maker, has recently gained attention in the market. DWF Labs, founded by Andrei Grachev, a Russian partner, in Singapore in 2022. The company claims to have invested in a total of 470 projects and partnered with approximately 35% of the top 1000 tokens by market cap in its short 16-month history.
Let’s review the incident:
4.1 Revelation
On May 9, The Wall Street Journal reported that an anonymous source claiming to be a former insider at Binance revealed that Binance investigators discovered $300 million worth of fake trades by DWF Labs in 2023. An individual familiar with Binance’s operations also stated that Binance did not require market makers to sign any specific agreements governing their trading behavior, including prohibitions on market manipulation.
This means that, to a large extent, Binance allowed market makers to trade as they pleased.
4.2 DWF’s Market Promotion
According to a proposal document sent to potential clients in 2022, DWF Labs did not adopt price-neutral rules but proposed using its active trading positions to pump token prices and create so-called “artificial trading volume” on exchanges, including Binance, to attract other traders.
In a report prepared for a token project client that year, DWF Labs even explicitly stated that it successfully generated artificial trading volume equivalent to two-thirds of the token and was working on creating a “believable trading pattern” that could bring “bullish sentiment” to project tokens if they cooperated with DWF Labs.
4.3 Binance’s Response
A Binance spokesperson stated that all users on the platform must comply with general terms of use that prohibit market manipulation.
A week after submitting the DWF report, Binance fired the head of the monitoring team and laid off several investigators in the following months, attributing it to cost-saving measures.
Binance co-founder He Yi stated that Binance has been monitoring market makers closely and strictly; market makers compete with each other, and their tactics can involve PR attacks against one another.
4.4 Possible Reasons
On the Binance platform, DWF is the highest level VIP 9, which means DWF contributes at least $4 billion in monthly trading volume to Binance. Market makers and exchanges have a symbiotic relationship, and Binance had no reason to offend one of its largest clients for the sake of an internal investigator.
V. The Main Operating Models of Cryptocurrency Market Makers
Like traditional market makers, cryptocurrency market makers also profit from the spread between buying and selling. They setLow buy-in prices, high sell-out prices, and profiting from the price difference, known as “Spread”, are the main basis for market makers’ profits.
After understanding this basis, let’s take a look at the two main business models of market makers for project parties.
5.1 Subscription Service + Trading Commission (Retainer + Performance Fee)
In this model, the project party provides tokens and corresponding stablecoins to the market maker, who uses these assets to provide liquidity for CEX order books and DEX pools. The project party sets KPIs for the market maker based on their own needs, such as acceptable price spreads, required market liquidity and depth, etc.
A. The project party may initially give the market maker a fixed setup fee as a start for market making projects.
B. Afterwards, the project party needs to pay a fixed monthly/quarterly subscription fee to the market maker. The basic subscription fee usually starts at $2,000 per month, and the specific fee depends on the scope of services, with no upper limit. For example, GSR Markets charges a setup fee of $100,000, a monthly subscription fee of $20,000, and an additional $1 million BTC and ETH loan.
C. Of course, some project parties may also pay KPI-based trading commission fees to incentivize market makers to maximize profits (incentives for market makers who successfully achieve KPI goals in the market). These KPI metrics may include trading volume (involving illegal wash trading), token price, bid-ask spread, market depth, etc.
In this model, the market-making strategy is clear and transparent, making it easier for project parties to control. It is more suitable for mature project parties that have already built liquidity pools in various markets and have clear goals.
5.2 Token Borrowing + Call Option (Loan/Options Model)
The most widely used market maker model in the market is token borrowing + call option. This model is especially suitable for early listing project parties.
In the early stage of listing, project parties often have limited funds and find it difficult to pay market-making fees. Since there is a limited circulation of tokens in the market at the beginning of the project listing, project parties lend early tokens to market makers, who also take on corresponding risks.
In this case, it is more suitable for market makers to set their own KPIs based on the project’s situation. To compensate market makers, project parties usually embed a call option in the market-making contract to hedge the price risk of the token.
In this model, market makers borrow tokens (token loan) from project parties to provide liquidity and stabilize the price of stablecoins in the market. The market-making period is generally agreed upon as 1-2 years.
The call option allows market makers to choose to purchase the borrowed tokens from the project party at a predetermined price (strike price) before the contract expires. It is important to note that this option is a right given to the market maker, not an obligation.
The value of this call option is directly related to the price of the token, providing market makers with the incentive to increase the value of the token. Let’s simulate a scenario:
Let’s assume that the Mfers project finds a market maker and signs a call option, agreeing to lend 100,000 tokens at a strike price of $1 for a period of 1 year. During this period, the market maker has two choices: 1) return 100,000 Mfer tokens at maturity; or 2) pay $100,000 (at the $1 strike price) at maturity.
If the token price rises 100x to $100 (yes, Mfers to the Moon), the market maker can choose to exercise the option and buy tokens worth $10,000,000 for $100,000, obtaining a return of 100x. If the token price drops 50% to $0.5, the market maker can choose not to exercise the option ($100,000) and directly buy 100,000 tokens at the market price of $0.5 to repay the loan (worth half of the strike price, $50,000).
Due to the existence of the call option, market makers have the motivation to manipulate prices to maximize profits. They have the incentive to pump up prices and sell, as well as to dump prices and buy back tokens at a lower price.
Therefore, in the token borrowing + call option (loan/options model), project parties may need to consider market makers as counterparties and pay attention to the following:
A. The strike price and the amount of token borrowing that market makers have, which determines their profit potential and market-making expectations.
B. Pay attention to the loan period, which determines the market-making space in this time dimension.
C. Termination clauses in the market-making contract, and the risk control measures in case of emergencies. Especially when project parties lend tokens to market makers, they have no control over the tokens’ whereabouts.
5.3 Other Business Models
We can also see that many market makers have primary investment departments, which can better serve invested projects through investment and incubation. They provide services such as fundraising, project promotion, and listing, and owning shares in invested projects also helps market makers reach potential customers (investment-lending linkage?).
OTC trading works similarly. Market makers buy tokens at a low price from project parties/foundations and use a series of market-making operations to increase the value of the tokens. There is more gray area here.
VI. Risks and Regulations
After understanding the operating models of crypto market makers, we know that besides the positive aspects of market makers in the crypto market, they not only cut the leeks but also “cut the leeks” of project parties. Therefore, project parties especially need to grasp the risks of cooperating with crypto market makers and the obstacles that regulations may bring.
6.1 Regulations
In the past, regulations on market makers focused on “securities” market makers, and the definition of crypto assets is still unclear, resulting in a relatively regulatory gap for crypto market makers and market-making activities.
Therefore, for crypto market makers, the current market environment is like a free-for-all, with very low costs for wrongdoing. This is also why they are synonymous with price manipulation, pumping and dumping, and cutting the leeks.
We see that regulations are continuously being standardized. For example, the US SEC is clarifying the definition of Broker & Dealer through regulatory enforcement, and the introduction of the EU MiCA regulation will also include market-making business in regulations. Compliance-oriented crypto market makers are also actively applying for regulatory licenses. For example, GSR Markets has applied for a major payment institution license from the Monetary Authority of Singapore (allowing OTC and market-making services within the regulatory framework of Singapore), and Flowdesk, which completed a $50 million financing earlier this year, has obtained a license application from the French regulator.
However, the regulations in major jurisdictions do not prevent some crypto market makers from operating offshore because they are essentially large capital accounts in various exchanges, and most of them do not have any onshore business.
Fortunately, due to the FTX incident and the continuous regulation of major exchanges such as Binance and Coinbase, crypto market makers coexisting with exchanges will also be restricted by the exchanges’ internal control compliance rules, making the industry more regulated.
We do need regulations to standardize these unethical/illegal behaviors, but before the industry erupts, we may need the industry to embrace the bubble.
6.2 Risks
Due to the lack of regulation, crypto market makers have the incentive to engage in unethical trading and market manipulation to maximize profits, rather than creating a healthy market or trading environment. This is why they have a notorious reputation and also bring many risks.
A. Market Risks for Market Makers
Market makers also face market risks and liquidity risks, especially in extreme market conditions. The collapse of Terra Luna and the collapse of FTX led to a chain reaction that caused market makers to collapse, leverages to collapse, and market liquidity to dry up, with Alameda Research being a typical example.
B. Lack of Control for Project Parties over Borrowed Tokens
In the token borrowing model, project parties lack control over the tokens lent to market makers and do not know what market makers will do with the project’s tokens. It could be anything.
Therefore, when lending tokens, project parties need to imagine market makers as counterparts rather than partners and consider possible scenarios due to price impact. Market makers can adjust prices to achieve various purposes, such as deliberately suppressing prices to set a lower price for new contracts or using anonymous voting for proposals that benefit them, and so on.
C. Unethical Behavior of Market Makers
Unethical market makers manipulate token prices, inflate trading volume through wash trades, and engage in pumping and dumping. Many cryptocurrency projects hire market makers to use wash trading and other strategies to improve performance metrics. Wash trading refers to the practice of repeatedly trading the same asset to create the illusion of trading volume. In traditional markets, this is illegal market manipulation that misleads investors about the demand for specific assets. Bitwise published a famous report in 2019 stating that 95% of trading volume on unregulated exchanges is fake. A recent study by the National Bureau of Economic Research (NBER) in December 2022 found that this number has dropped to around 70%.
D. Project Parties Bearing the Blame
Due to the lack of control over the tokens lent and the difficulty of restraining unethical behavior by market makers, or even the lack of knowledge of such behavior by project parties, the project parties responsible for the actual operation of the project will be held accountable if these behaviors come under regulatory scrutiny. Therefore, project parties need to pay attention to contract terms or emergency measures.
VII. Conclusion
Through this article, project parties can understand the significant contributions of crypto market makers in providing liquidity, ensuring efficient trade execution, enhancing investor confidence, making market operations smoother, stabilizing stablecoin prices, and reducing trading costs.
However, at the same time, by revealing the business models of crypto market makers and highlighting the risks that may arise from cooperating with them, project parties need to be particularly cautious when negotiating contract terms and implementing cooperation.
