The hidden cost of loan-and-option deals

What market making is in crypto

The concept of market making is deceptively simple — and often misunderstood.

Being an essential part of any financial market, the definitions, explanations, and examples of market making are ubiquitous, see for example Investopedia, Wikipedia, The Tokenist, or The Balance.

Essentially, market makers are actors who commit to stand on both the selling side as well as the buying side of the market. Too often, there are not enough buy (bid) and sell (offer or ask) — i.e. market liquidity is low. Market makers provide liquidity to make it easier and cost-effective for everyone to buy and sell an asset at any time.

Digital asset market making is even more complex than in traditional finance due to the nature of the underlyings and the market structures.

Gas fees and transaction costs, decentralization and market fragmentation make it difficult to track prices and make informed decisions: hundreds of disparate centralized and decentralized exchanges alongside incompatible blockchains need to be bridged. Underdeveloped regulation and business practices contribute to crypto’s volatility on top of the lack of readability of the assets themselves. Unlike listed companies, crypto assets have more complex business models and do not provide audited quarterly results.

On this ocean of uncertainty, more than in any other markets, tokens need liquidity support from market making.

Liquidity is always difficult to come by. If an asset’s market remains illiquid for too long, the token’s value will suffer, also making it susceptible to market manipulations.  Such an asset is unlikely to be listed (or stay listed) on high-tier centralized exchanges leading to a self-fulfilling prophecy of price deterioration over time. Ultimately, an entire project can go under with the price drop of its token.

This is why exchanges — including traditional stock exchanges — rely on market makers. In crypto, centralized exchanges usually obligate token issuers to contract one.

First-generation market making: proprietary trading in brief

Most market makers are proprietary traders, often trading firms.

They essentially take an interest-free loan” from the token issuer to get the tokens to be traded. Then, the proprietary market maker adds its own funds (usually in stablecoins or ETH) to market make — to be on both bid and ask sides of the token market.

Most proprietary traders offer their services for free — or so it seems. They make profits in three ways:

• on the bid–ask spread — by quoting prices that are higher on the sell side than the buy side, the market-maker can generate income, often called Profits and Losses” (P&L or PnL) just by buying and selling the asset throughout the day;
• on arbitrage — the occasional price differences among different exchanges; and
• exercising their call option — the contractual right to buy the borrowed tokens at a predetermined price at basically any time — and selling the tokens.

The problems of proprietary market making

Agreements between token issuers and proprietary traders include these call options which constitute a severe risk of conflict of interest.

The call option incentivizes token price increase — so that the proprietary trader can exercise its call option when the token’s market price rises above the predetermined contractual price. This way, it can make sizable profits on the tokens by selling them on the market.

After riding the wave higher and higher, the token’s market price might nosedive, and the token project loses many tokens and value. This destroys the trust and confidence that the project and the community has worked so hard to build.

In the proprietary market-making framework, issuers are at risk of losing control over a significant portion of their token’s supply. This is because proprietary traders’ activities are often a black box. Token issuers need to give them the benefit of the doubt, trust them to make the right calls and resist these bad instincts.

This is exactly the risk that blockchain was meant to eliminate. It was supposed to be a trustless technology.

These massive issues in market-making today do not even include gray areas” and illicit practices like insider trading or wash trading, creating fake trading volumes.

Market makers are not supposed to trade with themselves” or falsify transactions — but carry out actual buy and sell orders, help investors and the community exchange assets at fair prices.

In addition, being driven by their own P&L, market-makers have a tendency to be highly risk-averse during extreme volatility events. This means that they reduce or remove their liquidity at times when projects need liquidity the most.

Finally, proprietary trading as a business model is inherently unscalable. In crypto, a large portion of the profits of trading firms come from the exercise of the call options and the subsequent sale of the associated token. This means that market-makers assess projects on a case-by-case basis, betting on whether or not they could expect to call their option. In this sense, proprietary market-makers in crypto are more similar to venture capital than to quantitative trading firms. This incentive structure ultimately encourages pump and dumps — ultimately damaging the outlook of a token.

By being financially incentivized by their own P&L, proprietary traders often give preference to their own interests.

This is why we need to reinvent market-making. It must be transparent, scalable, and asset-agnostic — guaranteeing a full alignment of interests between token projects and the firm in charge of managing the liquidity.

The new standard for market making: Market Making as a Service (MMaaS) in brief

MMaaS was developed specifically to decrease the innate risks of the old, first-generation model of market-making, to make good on its original promise: ease token issuers’ burdens and build sustainable markets.

In contrast to proprietary trading, MMaaS does not involve a token loan. It is not even a financial service — rather, a technology service; similar to a software as a service” solution. Strictly speaking, it does not provide liquidity, but a liquidity management solution.

Under this model, it is the token issuer who provides both the collateral as well as the tokens to market make for. The token project can choose and set the market-making strategy, too. Hence what token issuers get, is the service itself: access to the trading infrastructure as well as the support of the sales and trading teams of the MMaaS provider.

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