With the empire of FTX collapsing, several other exchange platforms suffered too. Market makers and lenders were hit the hardest: Alameda, one of the largest market makers in the cryptocurrency industry, was wiped out in the fiasco and officially ended trading on November 10; Genesis, a market maker and lender owned by DCG, is also facing a lack of solvency.

With collapse of the head market maker, the massive principal wipeout, and the drastic one-sided market caused an unprecedented panic among the industry's market makers. The aftershocks saw market makers tend to shut down, communities and projects face huge stress tests, and the crypto industry's market liquidity suffered a significant drop.

For both traditional and crypto markets, talking about market makers has always been like playing a game of blind men's game for the general public investors.

Now let's start from the beginning and discuss the disenchantment of market makers.

What is a market maker, how do you make a market and how do you make a profit?

Wikipedia explains that a Market Maker is called a "Specialist" in the New York Stock Exchange market in the United States, a "dealer" in the Hong Kong stock market, and a "market maker" in Taiwan. In Taiwan, it is called "market maker".

As the name suggests, a market maker is the person who creates the "market".

In traditional financial markets, a market maker is a commercial organization, usually a brokerage firm, large bank or other institution, whose primary job is to create liquidity in the market by buying and selling securities.

Market making is an established and proven financial practice in which market makers provide liquidity and depth to the market, where buyers and sellers do not have to wait for counterparties to appear, as long as a market maker steps in to assume the counterparty to a deal, and the market maker profits from both sides earning the bid/ask spread. The difference between the bid and ask price in the market is Bid-Ask Spread, and the spread is the main way for market makers to profit (also through the trading platform rebates, the trading platform will pay some specialized market makers to increase trading volume and boost profits).

In a liquid market with many buyers, sellers and market makers, spreads are small and market makers need to trade a lot to make a profit. They use very sophisticated quantitative algorithms to take very short-term positions - from a few hours to a few seconds. The market is volatile enough that the more trades market makers are able to make, the more profit they earn.

In short, market making is the provision of two-way quotes to any given market, providing market size for both buyers and sellers; without market makers, the market would be relatively illiquid, which would impede the convenience of trading.

Market Makers in Crypto Markets

In both the traditional and crypto markets, liquidity is the lifeblood of all trading markets, and the market maker is a significant stakeholder. In crypto markets, market makers are also known as liquidity providers (LPs), which is perhaps a direct reference to the fact that, like traditional markets, crypto markets need market makers to solve the liquidity trap by helping to guide the "invisible hand" of the market.

This liquidity trap is mainly reflected in a vicious cycle: crypto projects need people (cryptocurrency exchanges and crypto investors) to contribute to token liquidity; at the same time, these people will only participate when the token has market liquidity, and this is where market maker comes in.

Simply put, market makers breed liquidity with liquidity, and a project typically needs to leverage the support of market makers to provide liquidity, confidence, and price upside to their token market until the volume is sufficient for them to maintain the trading ecosystem on their own.

What's do market makers do?

Take cryptocurrency as an example. Since liquidity is the foundation of any efficient market, it is crucial to reference to liquidity over and over.

• Pricing power: Market makers are able to track price changes over time, make judgments about fair market prices and provide the most informative quotes. Platforms such as 1inch, for example, not only direct the flow of funds to different pools, but also ask some market makers (e.g. Wintermute) to quote.

• Enhanced liquidity in the market: investors can trade directly with market makers without having to wait or find a counter-party. Market-making is the provision of two-way quotes to any given market, which is at the heart of providing liquidity.

• Improving the overall efficiency of the market: market makers help improve the overall efficiency of the market by quoting through various trading platforms and eliminating inter-market disruptions through arbitrage. For example, Kairon Labs currently connects to the APIs of over 120 exchanges, helping in reducing the impact of price volatility.

• Facilitates new token introductions and lowers issuance costs: market makers will drive the rise of trading volumes and a flood of new tokens on multiple cryptocurrency exchanges.

• Increasing trade volume and market expectations: attracting investor attention and boosting market confidence, which in turn drives up token prices

• Facilitating the conclusion of block trades: market makers are themselves suitable counter-parties to institutional investors for block trades.

Market Making Strategy

Market making strategy refers to a strategy that creates separate limit buy and sell orders, uses fluctuations of the underlying price to trigger the limit orders, and gains trading returns through the difference between the buy and sell orders. This belongs to the risk-neutral intraday spread arbitrage strategy in high-frequency trading strategies. Simply put, it is the middleman mentioned earlier to earn the spread.

Twitter user 0xUnicorn tweeted a detailed analysis of common market maker trading strategies in the categories of spot and futures, which I won't go into here. Of course, there are also strategies that are more specific: Delta-neutral market making (i.e. self-hedging inventory risk), high-frequency "instant" market making, grid market making, etc.

At its core, the focus in market-making strategies is on the number of limit orders and and the setting of the distance between the bid and offer orders and the mid-price, and thus in all types of classical market-making strategies, the main study is the estimation of the mid-price, and then set the buy and sell orders at the appropriate positions on either side of the mid-price. Therefore the market maker's greatest fear is a sharp one-sided market, because it means that buy and sell orders will be traded one-sided and a large number of risky positions will be accumulated in their hands.

Risk, opportunity and the Wild West

As mentioned above, the risk comes mainly from inventory risk

When a large amount of inventory accumulates on hand, it also means that there is a greater likelihood that market makers will not be able to find buyers for their inventory, leading to one risk: holding more assets at the wrong time (usually in devaluation). Another scenario is that the market maker has to start selling inventory at a loss to keep operating when the price of the asset rises.

Market making risks may be handled more carefully in DeFi. An example is the perpetual contract. Market makers often use the funding rate of perpetual contracts (the core of the mechanism is to have the contract price anchored to the spot price) to arbitrage spot and leverage. In a nutshell, this type of arbitrage involves creating a position in the spot/leveraged and perpetual contract markets with the same value and opposite position direction, respectively. Market makers are therefore exposed to significant liquidation risk under abnormal price movements, as the positions they hold as a result of arbitrage at different funding rates can be large.

The opportunity comes from the high reward behind the high risk. Even with a spread of $0.01, when such an order is executed a million times in a day, the profit will reach $10,000. Market makers also provide traders with leverage and will be able to liquidate a trader's margin in the event that a client's position is blown. According to coinglass data, cryptocurrency blowouts range from $100-$1 billion per day. This will drive huge profits for market makers.

There is no denying that the crypto market is still in its early days, and there is still a frantic side to running here relative to the very sophisticated market making operations in traditional financial markets. If we zoom in and look at some of the details of crypto trading: the relatively low liquidity of assets; significant slippage risk; and the high potential for flash crashes when large orders come in or when a large number of sell orders cancel the best buy offer in the order book. These characteristics, too, often lead to some hidden corners, or gains, for crypto market making.

Overall, the crypto market and users are still filled with the chaotic feeling of the blind leading the blind as far as market makers are concerned due to technical and regulatory factors.

When it comes to the Wild West. When a market maker promises a token issuer a specific level of trading volume, the next step will be a more ambitious promise: the token price will rise to a specific level. How is this done?

• Wash Trading: A beginner trader will place a large sell order and within seconds place a buy order of his own. An advanced player will use smaller orders, placed for a longer period of time; while operating from multiple accounts rather than one in order to avoid exchange detection.

• Pump-and-dump: Of all the price manipulation tactics, the practice of pulling up and shipping out is particularly common. Social networks are the best front-runners, and once there is enough FOMO, a large number of tokens purchased in advance can be sold at a profit.

• Ramping: Ramping refers to creating the impression of being a big buyer. Market makers can use this strategy to create a "big buyer" who trades large amounts at regular intervals, where the fomo sentiment comes into play again and other traders rush to get ahead of the "big buyer" (but end up as losers) -When the market takes notice of such behavior, the price naturally rises. Of course, once the market maker activity ends, the ghost buyers mysteriously disappear and the price of the token is likely to plummet.

• Cornering: When a token has multiple market makers at the same time, a particular market maker can make money by trying to buy most of the available tokens, forcing the other market makers to raise their prices because they have to keep the spread at the same level.

Due to the complete lack of regulation, these speculative operations do appear in the strategies of market makers, and they end up disrupting the market, erasing confidence in the traded assets, causing people to lose the trust of the listed exchanges. Thus, affecting the reputation of the project parties and leading to long-term losses.

Yes or No：Everyone is a market maker

Market makers vs. Automated market makers

While Market Maker (MM) and Automated Market Maker (AMM) may sound similar, they are completely different entities.

As mentioned earlier, in traditional finance, a market maker is an institution or platform that offers to buy and sell transactions in various types of securities to multiple exchanges, providing liquidity to the market and profiting from the bid-ask spread.

While AMM is a decentralized exchange (DEX) protocol, unlike traditional exchanges that use an order book, assets are priced according to a specific pricing algorithm, with the pricing formula varying from protocol to protocol. For example, Uniswap uses the following mathematical curve to determine the transaction price: x * y = k. Where x and y are the quantities of two assets in the liquidity pool, y is the quantity of another asset, and k is a fixed constant, meaning that the total liquidity of the pool must remain constant.

AMM works similarly to traditional order book trading platforms, both of which set up trading pairs (e.g. ETH/DAI). However, the former does not require trading with a specific counter-party. In the AMM mechanism, the trader interacts with the smart contract to "create" a market for himself. Liquidity in a smart contract is provided by a liquidity provider (LP), which in return for providing liquidity to the protocol, earns a fee from the transactions carried out by the trading pool.

AMM：Everyone is a market maker

While in traditional financial terms, AMM refers to an algorithm that simulates human market maker behavior, in the DeFi space it has evolved into an engine of violence:

It uses an automated algorithm to balance the supply and demand of tokens in the trading pool, avoiding a situation where a one-sided market may result in a particular generation being bought short (no buyers/sellers pending in the market) and unable to trade; unlike other market makers, for example, CEX's market makers earn the bid/ask spread and they control their inventory by adjusting their positions according to their strategy to make a profit, DEX's market makers provide liquidity differently compared to CEX. Unlike CEX, DEX market makers also earn a commission; when this trading commission is given to liquidity providers, it will provide them with an incentive to inject idle assets into the trading pool to provide liquidity, which in turn solves to some extent the problem of insufficient depth of trading in the order book model.

AMM-based DEX has proven to be one of the most influential DeFi innovations, and it was AMM that came along to break the limits of order thinning and aggregation, helping DEX break the CEX monopoly on the cryptocurrency trading market and making open and free on-chain trading a reality. It was also AMM that allowed ordinary users to participate in market making in a permisionless way, allowing every DEX to shout the proud slogan that everyone is a market maker.

No licenses required, efficient and transparent, self-creating markets, and everyone enjoying the benefits of liquidity creation.The vision of market making as outlined by DEX appears to be too.

Why LPs suffer loss?

Time to move from vision to reality.

The first question is, will users make profits while making market on a DEX as an LP?

(voice: have you forgotten the impermanent loss?)

In a widely cited study on Uniswap v3 LP losses, REKT brutally states: as a group [users] would have been better off HODLing than providing liquidity on Uniswap v3.

As Rekt indicates, during the launch of V3 from May 5 to September 20, 17 asset pools with TVL > $10M (43% of TVL) traded over $100B, earning LPs approximately $200M in fees. However, during the same period, over $260M was lost due to IL, resulting in a net loss of over $60M. In other words, about 50% of V3's LPs are losing money.

While Uni V3 popularized the concept of leveraged liquidity provision, where it narrows down the scope of transactions providing liquidity and achieves a higher degree of capital efficiency by eliminating unused collateral. This leverage increases the accrued fees and the risk simultaneously, as highly leveraged liquidity will be exposed to higher impermanent losses.

The reason is the design goal of Uni V3: customized market making. For users, higher initiative means that market-making has more complex. LPs' return depends on their judgments of the market, increasing decision costs, finally leading to uneven LP returns. This design also made JIT (Just In Time) attacks a more widespread phenomenon. JIT attacks mean that MEV searchers use V3's centralized liquidity to add and withdraw LP positions within the same block, define the range of positions to match the transactions, and scoop up a large portion of transaction fees.

Improving capital efficiency when losing the revenue is not what LPs want.

This leads to the next question: If a user makes a market on a DEX, will he or she 100% lose money as an LP?

Let's answer this question briefly: DEX market makers are profitable or not depending on what model of the pool they trade, in addition to their subjective ability.

• Traditional AMM pools: There is no difference between ordinary users and professional market makers to make profits from providing liquidity. AMM algorithms limit the capital and external quotes of professional market makers. Essentially, it is a TVL contest, which determines who gets the higher fees.

• Pools with customizable prices: such as Uni V3, Balancer V2, Curve V2, DODO V2. In these pools, market makers can actively intervene in the quotes of the pool. They can also make profits from the price and lag difference between the CEX and DEX (meanwhile, there are plentiful DEX aggregators. Better quotes mean that the pool has a higher probability of being tracked by the aggregators).

One of the reasons why LPs lose money is because they choose programs that don't work for them.

So why do the leading DEXs offer customizable pools? When the liquidity evenly distributes on the curve, not only Uni V3, other DEXs face the problem of high slippage and fragmented liquidity. Therefore, DEXs with traditional AMM algorithms want to improve capital efficiency. Uni V3, Balancer V2, Curve V2, and DODO V2 are a case in point as they are optimizing in concentrated liquidity.

In contrast, the advantage of active market making is that users can concentrated liquidity to a specific interval by adjusting prices, improving capital efficiency with lower trading slippage and greater market depth. These are also its disadvantage. It somewhat raises the threshold for users to participate in market making, despite being more suitable for professional market makers, and improves the possibility of earning. Must admit the risk of losing money. Ordinary users, after all, cannot compete with professionals in terms of professional skills and market sensitivity.

This slogan, “Everyone is a market maker,” truly means that everyone can become a market maker but not be a good one.

Head market makers collapsed: After the Market loses liquidity

Market Maker in the Domino effect

The collapse of FTX empire hit multiple leading platforms, where market makers and lenders are experiencing severe. Alameda, one of the largest market makers in crypto, was wiped out in the fiasco, and officially ended on November 10. Genesis, a market maker and lender, owned by DCG, has suspended redemptions and new loan issuance due to its insolvency triggered by the FTX downfall and is seeking $1 billion in emergency loans from investors.

Market makers as a key role in the falling dominoes has these implications:

• Market liquidity declined significantly

FTX meltdown - Market maker collapse - Liquidity gap. As the head market maker disappears, a significant drop in market liquidity can be expected. Other market makers will also suffer huge losses brought by the fall of FTX, which will continue to widen the liquidity gap. The reality also points out a harsh fact that the crypto liquidity is dominated by a handful of trading firms, including Wintermute, Amber Group, B2C2, Genesis, Cumberland, and Alameda. Only six months after the Three Arrows‘ credit crisis in May and June, the market was again overshadowed, where market makers are in a cascaded struggle.

According to Kaiko's data tracker, BTC liquidity within 2% of the mid-price has plummeted from 11.8k BTC to 7k, the lowest level since early June, since CoinDesk's article unveiled the asset position held by Alameda. This article also alleged that, as data shows, the Alameda crash and the losses suffered by other market makers are straining the market liquidity.

Thankfully, market depth has slightly climbed in the past week, suggesting that market makers are redeploying capital. However, it is a gradual process.

• Token Liquidity and Stress Testing for Projects

Alameda has invested in dozens of projects holding millions of dollars worth of illiquid tokens ( Alameda is also a market maker, the primary liquidity provider for these tokens). While the details of tokens held by Alameda and FTX are not yet clear, according to FTX balance sheets provided by the Financial Times, "[it] is a systemically important market maker." Especially for token liquidity besides BTC and ETH, the extreme market conditions brought on by the implosion would have been a stress test for projects.

Take SOL (Solana), one of the major assets in Alameda Research's accounts, as an example. According to CoinDesk, Alameda held about $1.2 billion in SOL tokens on June 30. SOL was one of the best-performing tokens in the 2021 bull market, now down 95% from its all-time high.

Such crash: first, it brings a liquidity crunch and poses risks to DeFi through mass liquidation, which could also saddle lending agreements with bad debt. Two, it leads to confidence collapse and massive loss of staking tokens, increasing the likelihood of disruptions posing the risks of stability and security, reducing the cost of cyber attacks.

• Burst of confidence and trust

More importantly, both confidence and trust crushed.

Confidence: The "Black Swan" event has impacted the industry's confidence in the so-called high-performance public chains and, to some extent, destroyed the confidence of users and supporters in a series of ecological projects under FTX. Confidence is worth more than gold, and fear is scarier than hell. The crypto market has experienced two Lehman moments in six months, Luna/Terra and Three Arrows Capital, which taught users what uncertainty is and brought panic spreading faster than a virus to the market.

Trust: In the collapse of Alameda, we can see how top market makers in the industry ran wild. For example, their trading business was controlled by FTX with improper use of client funds. And investors and projects know nothing at all. Of course, it is a concession of trust that CeFi had from the public since the beginning, but when reputable and prominent market makers showed their naked ugliness, your bubbles of trust burst. Despite the fact said thousands of times: FTX / Alameda ≠ Blockchain.

After the market loses liquidity

As mentioned earlier, in any market, liquidity is the driving force.

When the overall market spins downward, the withdrawal of head market makers adds to the problem, which means more projects and investments stall. Here again, a vicious cycle occurs (until the fundamentals recover) :

Market slowdown - liquidity falls, or a major crisis emerges - sharp Unilateral quotation - market-making activity falls - trading volumes and investment activity fall - liquidity falls -Market slowdown.

Many market makers provide liquidity to blockchain exchanges and financial protocols to maintain the crypto market liquidity. As a result, in the absence of market-making or a sharp drop in market-making activity, there may be low trading volumes and reduced investment. We need to make a distinction: it is normal that liquidity will experience a decline during volatility. The reason is that market makers take ask/bid mandates from the order book to manage risk and avoid distressed flows. However, a sharp decline due to a significant crisis event, market maker drawdown, and market liquidity will experience severe challenges for some time.

As you can see, the current liquidity is experiencing a severe decline ever. At the same time, the market recovery amid a bear market is prolonged, suggesting that this liquidity gap will likely continue in the short term.

So what should be done?

How does DODO meet the demand for market making?

As mentioned earlier, we actually provoked two questions:

1. How do market makers gain revenue when AMMs are optimizing towards concentrate liquidity, and when becoming an LP comes with challenges or even losing money, how can market makers profit?

2. How to rebuild trust and leverage the decentralized nature of crypto to bring tight liquidity to projects after the collapse of FTX led to the crash of head market makers and declining market liquidity? How to bring true permissionless and efficient transparency to market makers?

The answer to the second question is evident when posed: Use DEX, Use Blockchain. Go back to the chain, to the code, to "don't trust, verify".

Regarding the first question, many protocols or platforms already provide liquidity management tools to help LPs manage risk and stabilize returns. There is a solution from DODO: bringing professional market makers to the chain. In the article "Interview with DODO‘s Market Makers: How to Use DODO to Improve Market-Making Efficiency”, Shadow Labs, a market maker, mentions that after deducting various expenses such as gas, they get 30-40% net profit of on-chain public revenue. For example, market makers have a year-to-date net gain of $500k after deducting various fees from DODO‘s WETH /USDC pool, which is about 36.2%.

So how to achieve it?

As we all know, AMM is often called "lazy liquidity". It offers uncontrollable price points to traders and is not as informed and flexible as traditional market makers. DODO, therefore, stepped in and pioneered the PMM (Proactive Market Making) algorithm, using price prediction to adjust the pricing curve with simple yet flexible parameters, a flatter curve to effectively improve capital utilization and reduce trading slippage and impermanent loss. For more information on the efficiency gains of how different algorithms plays in improving the efficiency of concentrated liquidity, read our piece: Deep Research in the Market Making Algorithm of UniV3, Curve V2, and DODO — the Efficiency Improvement Brought by Concentrated Liquidity.

Beyond these, we would like to talk about DODO's V2 release that went live in March.2021 with the introduction of DODO Private Pools (DPP), pools exclusively available to professional market makers to operate their own liquidity pools.

Private Pools, as the name implies, can be used by market makers to provide their own funds for independent market making and have the flexibility to modify the private pool configuration during the market-making process, including trading commission rate, current external guide price i, curve slippage factor K, as well as support for adjusting the pool's capital size, etc. Modifications are realized by smart contracts either calling the DODO DPPProxy contract or directly calling the underlying private pool for market-making modifications. Operation steps can be found in: DODO Private Pool (DPP). Therefore DPP pools satisfy professional market makers' particular needs.

In terms of Yield performance, DODO statistics state that market makers have a total return of 16% on Polygon WETH- USDC, and a total return of 10% or even 22% on BSC (launched at the end of July) in the last four months. The overall performance is quite impressive.

In addition, the article Deep Research in the Market Making Algorithm of UniV3, Curve V2, and DODO — the Efficiency Improvement Brought by Concentrated Liquidity analyzes the capital efficiency gains from concentrated liquidity through the performance of liquidity distribution data. By selecting WETH/USDC pool as a sample, the article shows the average values of liquidity ratios in the price range of 2%, 6%, and 10%. DODO V2's market maker pool has a high liquidity ratio in the 2% range of 83.1%.

Attracting professional market makers to the chain, as decentralized exchanges are naturally trustless, non-custodial, and permissionless, is where the future of trading and market-making lies. But solutions AMM has slowed down the progress as cost and efficiency issues. DODO's PMM algorithm and DPP private pools provide professional market makers with a flexible market-making curve, reducing market-making costs, improving capital efficiency, and bringing outstanding experience. It is also a better cooperation option for projects in a market environment of declining liquidity.

Reference

https://foresightnews.pro/article/detail/5995

https://twitter.com/0xUnicorn/status/1592007930328776706?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed&ref_url=https%3A%2F%2Fwww.notion.so%2Fbe02a02105b5470e83fff8f06425e298

https://twitter.com/NateHindman/status/1457744185235288066?s=20&t=jb-YsLK25pE8GuHZaMAudg

https://medium.com/wintermute-trading/the-good-the-bad-and-the-ugly-of-crypto-market-making-hacker-noon-c0c4fd55263a

https://www.chaincatcher.com/article/2062401

https://www.notion.so/4bb203cb20654a058482e59ce2fddb62

https://www.notion.so/DODO-DODO-97a9cbbaa925431d88f110754446cdf9

https://rekt.news/uniswap-v3-lp-rekt/

https://www.coindesk.com/business/2022/11/09/who-still-has-exposure-to-ftx/

https://blog.kaiko.com/crypto-liquidity-in-a-post-alameda-world-5fb2c190f0b

https://newsletter.banklesshq.com/p/is-solana-dead

About us:

「Dr. DODO」is the research arm of DODO. We track the evolvement of DeFi and related sectors. Dr.DODO leads a group of researchers to decode the crypto world, conduct in-depth research, publish distinctive views and predict the future value of the crypto world

Our DM is open! We welcome any insights & original writings.

Contact: email: [email protected]

We’re Hiring：

https://twitter.com/DodoResearch/status/1601066101001302018

1)DeFi / Web3 Infrastructure Researcher

2)Brand Operation

Our work are published at Twitter, Notion and Mirror：

Twitter: https://twitter.com/DodoResearch;

Notion: https://dodotopia.notion.site/Dr-DODO-is-Researching-6c18bbca8ea0465ab94a61ff5d2d7682;

Mirror：https://mirror.xyz/0x70562F91075eea0f87728733b4bbe00F7e779788