Market Making Types: Manual, Automated, and Decentralized

What Is Market Making?

Conventional market making brings buyers and sellers together to create a marketplace for stocks and other securities. Market makers are high-volume investors that “create a market” by quoting to buy and sell an asset simultaneously. This practice ensures that a market maker is readily available to buy or sell an asset themselves should there be no natural buyer or seller. As a result, market makers act as buyers and sellers of last resort. Market makers profit on the spread between the bid and ask prices and provide crucial liquidity services to the broader market. Liquidity refers to the ease with which an asset can be bought or sold without affecting price stability.

Market Makers and Liquidity Services

Adequate liquidity stands to benefit all stakeholders, as it helps make financial markets more efficient by reducing price volatility and supporting fair prices. Market liquidity is dependent on order books — the collection of active buy and sell orders for a particular market. The difference between the highest bid price and the lowest sell price is known as the bid-ask spread. Markets with low liquidity will often have a wide bid-ask spread, which is typically indicative of low volume. Conversely, more liquid markets often have a tighter bid-ask spread and higher volume. Market makers actively facilitate liquid markets by posting tighter spreads.

Market makers will often buy and sell securities for their accounts and post prices to an exchange platform with the goal of generating profit on the bid-ask spread. The bid-ask spread is how much the asking price exceeds the bid price; the difference generates a profit for the market maker. The fee compensates market makers for the risk they assume when they buy and hold assets that decline in value after purchase, but before resale.

Who Are Market Makers?

The speed and ease of trading stocks continues to improve — especially since the advent of app-based investing. Through app-based platforms, users can execute trades within seconds, depending on the type of market order. However, behind the scenes, it’s market makers that help to ensure that this process occurs efficiently. The most common type of market makers are brokerage houses that offer purchase-and-sale services to investors. These brokerages aim to keep financial markets liquid while also generating a profit for themselves.

Automated Market Makers (AMM)

Unlike today, the earliest market makers didn’t have the luxury of automation. It wasn’t until the early 1990s that Shearson Lehman Brothers and ATD first implemented automated market makers (AMMs). Before this, order books were the product of manually initiated trades meant to improve market liquidity. This manual approach to market making caused slippage and price discovery latency, while the lack of transparency led to accusations of market manipulation.  AMMs solved these problems by removing humans from the market-making process, which also enabled near-instant trades and greater transparency.

Decentralized Market Making

In recent years, automated market makers have become increasingly popular on decentralized cryptocurrency exchanges (DEXs). On these platforms, traditional order books are replaced by liquidity pools composed of two different cryptocurrencies. In the realm of DEXs, AMMs quote the price between two digital assets simultaneously. Virtually anyone can become a market maker by providing liquidity to a select pool. These so-called liquidity providers (LPs) earn passive income on their deposits that is proportional to the percentage of liquidity they provide to a pool.

Notably, every 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. Protocols like Curve and Balancer also use simple formulas like this one. Others, like Bancor, which seeks to mitigate the impermanent loss that market makers can incur because of price fluctuations between the purchase and sale of the crypto asset in question, use more complex formulas.

Crypto Market Making and Institutional Investing

Over the years, market making has become an increasingly widespread facet of the cryptocurrency industry. The rising quality and quantity of traditional market makers in the crypto space providing liquidity via centralized exchanges (CEXs) has functioned as an important gauge of the crypto industry’s maturity, and has contributed to institutional investors’ expanding involvement with crypto. While reduced volatility and slippage, two of the primary benefits that market makers provide, certainly extend to retail investors dealing in smaller order sizes, their importance is magnified for institutional investors such as hedge funds, investment banks, and family offices who may be trading millions, or even billions, of dollars. As more institutional money enters the crypto sector — encouraged by, among other things, the development of more robust market making on CEXs — the industry stands to mature even further, opening up new possibilities in the world of crypto.