Before we jump into the topic of crypto liquidity and crypto market making, let’s get an overview of the current situation with crypto in general, especially when it comes to trading on CEXs and DEXs.
In recent times more and more projects and users worry increasingly about the effects of government interference in the form of investigations for non-compliance within an obscure, partly unregulated, or poorly executed realm of cryptocurrency regulations (think SEC vs. Binance). On top of that scandals like the FTX debacle, for instance, have also put a dent in crypto confidence for many. While the EU now spearheads by having adopted MiCA (Markets in Crypto-Assets Regulation), and possibly paved the way for more clarity, especially in terms of compliance, in many other parts of the world, the situation is still much murkier and government institutions are coming down heavily on crypto companies. In the USA for instance, the SEC is currently causing lots of confusion and enragement among builders, investors, and users alike. This has already resulted in many projects and traders fleeing certain countries to escape the wrath and scrutiny of regulators.
Another result of these developments is that businesses and users are increasingly making the switch from centralized to DeFi (decentralized finance) platforms, i.e. from CEXs (centralized exchanges) to DEXs (decentralized exchanges). And while DEXs are in many ways safe – or safer – from the prying eyes and cunning hands of governmental control, decentralized exchanges operate on a different principle than centralized exchanges, and trading there comes with its own challenges.
How trading on decentralized exchanges differs from centralized ones
Centralized exchanges are actual companies run by the company owners, as a business. This means that to not get into trouble with the local laws, CEXs usually have to abide by strict regulations, such as KYC (know you customer), which forces you to submit and verify personal data, such as an ID, to be able to trade on the platform. This varies depending on the platform and country it is registered in. While centralized exchanges operate on “classic” order books, much like in TradFi (traditional finance). These order books are basically lists of orders from potential buyers (bids) and sellers (asks) and orders get filled based on an order matching system to find a well-matched price. However, this largely depends on the depth (price level number) of the order book and the crypto liquidity provided for a given asset. The difference between the bid and ask prices for an asset is what is called “spread”. The bid-ask spread is the gap between the highest bid and lowest ask.
Decentralized exchanges rely on distributed governance among the people who use them. They are meant to be used in a trustless way, which means no interpersonal trust is required because everything is checked and executed through computer code using algorithms, smart contracts, and the like. Because they are not run like traditional companies with a CEO and owner, they are also not registered in the same way and don’t require KYC, meaning they can be used anonymously, without providing personal data. However, this also means that there’s usually not a classic order book to be found.
The way trades are facilitated varies from DEX to DEX. DEXs are peer-to-peer exchanges, i.e. there is no middleman or institution involved in the trades as they happen directly between two parties without the need for external custody of funds, directly between two wallet-holders (traders). The way this works is through leveraging the power of so-called smart contracts, which are pieces of blockchain code that automatically get triggered when certain predetermined criteria are met and execute the programmed functions accordingly. This process is thereby fully automated. Much like centralized exchanges, which can charge taker fees and maker fees, as well as withdrawal fees, DEXs also charge transaction fees.
Liquidity is key to staying afloat in volatile markets!
Different types of crypto liquidity providing, market making & order matching on decentralized exchanges
Automated Market Maker
The biggest player in the DEX space using automated market makers (AMMs) is probably Uniswap. AMM is a system relying on smart contracts using blockchain-based oracles as an instrument to determine the price and other relevant data and using crypto liquidity pools (LPs) to provide asset liquidity. These asset pools are filled by users who, in turn, get rewarded with the transaction fees that are charged for trading. They need to deposit equal parts of both trading pairs to the pool.
The biggest issues with AMM systems are impermanent loss and slippage. Impermanent loss happens because of the duality of the asset trading pairs. When one is more volatile than the other it can result in a reduction of one asset, which means a potential (impermanent) disadvantageous difference between the worth of the asset when it was initially committed to the pool and what it would be worth if one were to withdraw – at a loss. Slippage is the difference between the price traders expected and what the actual price turned out to be, e.g. when a lack of crypto liquidity causes unexpectedly high prices for a buyer, which gets worse with the amount of asset that was bought at such a “bad” price.
To conquer the problem of liquidity provision in DEXs, aggregators try to combine several different methods to counter the lack of liquidity, aggregating data from various DEXs into one order book using smart contracts. This method is used by the popular platform 1inch for example. However, less popular tokens or those that struggle with crypto liquidity, in general, will still suffer from illiquid markets, even with aggregation.
Order Book DEX
Order books on DEXs would work much like traditional order books, a compilation of open buy and sell orders. They can either be stored on- or off-chain. They try to bring the benefits of order-book-based centralized exchanges to DEX users, and can also offer leverage trading. However, they also often face great liquidity issues and have a hard time competing with CEXs with regard to the fact that on top of the “classic” fees, they also require users to pay extra fees for transacting on-chain. This technology is simply not mature enough to compete with CEXs at eye level yet. One example would be dYdX (off-chain order book & matching engine).
Crypto Liquidity and market making
How does crypto liquidity provision work in crypto?
What do we actually mean by the liquidity of an asset? Liquidity determines how easily one can sell or buy assets without greatly impacting the asset’s price. For a market to be truly liquid, lots of buyers and sellers with significant volume committed to the order book are necessary. In general, this means that big, bulk orders are not as likely to change the price and highly liquid markets have a decreased spread. In turn, this means that markets with low liquidity often face issues of tremendous price impact, less stability and more volatility, big spreads, and stagnation.
What is a crypto market maker?
Market makers participate in the markets in their own or in their customer’s interest, to provide crypto liquidity and stability to markets, especially to offset risks in highly volatile times or markets, such as the realm of cryptocurrency. They can aid in maintaining a tight bid-ask spread (the difference between the price at which an asset can be bought and sold), which enables market participants to trade with ease. The increase in crypto liquidity can also help to diminish token price volatility. Additionally, market makers can manage order flow, provide hedging techniques, improve price discovery, and much more, using sophisticated trading algorithms to achieve their goals in a highly efficient, fast, and automated way.
Crypto Liquidity provision on DEXs
DEXs can use different systems, such as automated market makers, on- or off-chain order books, or aggregators. Liquidity is a tremendous issue for many decentralized exchanges and various methods are being tested to improve this. However, at this point in time, there is still a lot of room to grow and improve in this sector. With the growing number of DEXs available, one way to leverage market makers is to ask for algorithmic arbitrage strategies or similar advanced ways to leverage the DEX variance. Spreads cannot be tightened as easily as on CEXs and solid liquidity usually requires a lot of capital committed to the pools.
Crypto Liquidity provision on CEXs
Most reputable centralized exchanges and token projects know how essential sufficient crypto liquidity is for their assets and their businesses as a whole. This is why they rely heavily on professional market makers to help them provide liquidity for their assets. There are two different kinds of crypto market making concepts in general:
A) The ones who provide liquidity using their own funds to trade and (ideally) profit from the PnL (profit and loss) made thereby, generated by spread (for example: companies like Cumberland)
B) Market makers that trade in their client’s best interest with their client’s funds, using complex individual strategies, so that PnL stays with the client and trading activities are best aligned with the client-company goals (for example: crypto market making companies like Autowhale).
Know yourself, know your exchanges, know your coins.
Whichever route or provider a project chooses, market making – or the topic of sufficient crypto liquidity more broadly speaking – is something that all projects need to seriously consider if they want to withstand high-volatility markets such as the crypto space and aim for long-term healthy markets, adequate price discovery, and a happy community of traders and supporters. Whether or not you decide to launch your project or trade your crypto assets on a CEX, DEX, or both, you should always be mindful of the particularities involved with each of these models. As with all things, knowledge is key, and thorough research (DYOR!) and strategy adjustment are vital for success in crypto.
Quick Overview – The biggest pros & cons of CEX vs. DEX
- better liquidity (esp. top tier exchanges)
- some have insurance
- more opportunity for market making & algo trading (lower fees)
- not trustless (risk of fraud, hacks, lawsuits)
- using hot wallets (think “Not your keys, not your coins!”, Andreas Antonopoulos’ mantra)
- not anonymous (KYC required)
- trade with your own wallet