The recent volatility in the crypto market, brought on by the downfall of one of the largest crypto market makers Alameda and FTX, has dealt a significant blow to the reputation of the crypto market making industry. As a founder of a market making and algo trading startup, I want to share some insights and provide some informed criticism about my industry.

Generally, I want to distinguish between two types of market makers:

1. profit-driven fund-like market making setups such as trading desks or hedge funds that perform some sort of market making/market-neutral trading activity and
2. market makers hired by token projects or exchanges.

The Fine Line between Liquidity and Manipulation in Crypto Markets

While the first type is largely accountable and ethically responsible for their own trades and has no duty other than to its investors, the second type works together with a specific token project or even an entire exchange and should act in their interest.
There is a very fine line separating conflict of interests and genuine market making practices.

This is mainly a result of either market makers compensation depending on the profitability of the operation which may ultimately lead to the market maker acting in the interest of their own pockets rather than overall market health, the type of compensation or the fact that crypto market makers are connected to exchanges which token projects are (in some cases) almost forced to use on their markets if listed on such an exchange.

Another not directly related but relevant bad practice is the generation of fake volume facilitated by wash-trading. Thankfully, the industry has somewhat caught up to this (see liquidity metrics and scores iE on CoinMarketCap), however it is still a practice market makers do, that on the one hand is easy to spot and on the other hand causes harm for the success of a project in the long run.

The collapse of Alameda Research and its role as a crypto market maker

Specifically, the first and second practice was — allegedly — part of the collapse of Alameda Research. The trading firm allegedly got a relevant stake in unlocked tokens of its clients for market making initially upon receiving marked at a low price, that quickly after secondary market listings increased in value resulting in large paper gains that could never be realized given the liquidity of most altcoin markets.

In order to realize at least some profits for maintaining and growing operations one is therefore forced to dump some the tokens on the open market which ultimately adds order-flow to the sell-side rather than the buy-side which results in a net negative for token projects hiring market makers operating on such a model.

Crypto market makers are a necessity for functioning digital asset markets

Market making in crypto is, nevertheless, if done in good faith an integral part of the industry which needs to be recognized and understood as such. Market makers quote prices

for markets so that (retail-) investors can trade assets at somewhat close spreads no matter what the market looks like. A lack of market makers would result in high transaction costs for traders and ultimately stopping the growth of the industry.

Green Flags to look for in a crypto market maker

Exchanges or token projects are the most likely types of businesses to interact with market makers. Such companies should look out for a variety of green flags that I want to discuss briefly.

1. To address that previous criticism, the almost most important part is the compensation model. Ideally, a token project should look out for market making companies operating on a fixed fee structure or at least a model that is communicated transparently and fully understood by the client.
2. Having the right algorithms and strategies in place is key. Ideally, the token projects should be able to determine the exact strategy and have the last word on decisions made.
3. As a project should avoid directly sending funds to market makers, a common practice is to provide API Keys that the market maker uses and integrates in its software. Market makers who ask for withdrawal or other unnecessary rights or store keys in plain text (see — allegedly — 3commas) should be avoided.

Ultimately, the industry and the crypto market making space has a long way to go, but companies building the infrastructure right now are surely in a very good position to grow and out-compete ill-intended competitors in the long-run.

Disclaimer: None of the content above is financial advise and is for educational purposes only.

Details:

Mail: thomas@autowhale.net
Twitter: @AutowhaleThomas
LinkedIn: https://www.linkedin.com/in/thomas-pratter/