The Hidden Role of Market Makers in Crypto

Source: CryptoNewsNet Original Title: The hidden role of market makers in crypto Original Link:

Understanding Market Makers

Traders often point to volatile market events and claim the price was artificially manipulated, blaming market makers in crypto. Data frequently reveals market makers moving vast sums on the blockchain just before significant price moves and market direction shifts. Price anomalies such as rapid crashes, pumps, price gaps, or widening spreads are often attributed to market maker activity.

In the crypto space, market makers are always present and sometimes more influential than whales. While their role may be indispensable, their actions sometimes go against retail trader expectations and appear as forces of market chaos.

What is a Market Maker?

Market makers operate within strict technical parameters. Their primary role is ensuring cryptocurrency markets maintain predictable liquidity by continuously maintaining buy and sell orders. Without market makers, cryptocurrency trading would require exact price-point order matching, making trading highly inefficient.

Market makers determine spreads by setting buy and sell orders. The spread—the difference between bid and ask prices—allows market makers to profit by selling higher and buying lower. Typically, market makers maintain smaller spreads to enhance market efficiency.

While market makers receive complaints about swinging markets in particular directions, they are generally risk-neutral. Unlike hedge funds or derivative traders, they don’t bet on market direction but instead rely on bid-ask spreads for earnings.

Market makers carefully track token and stablecoin inventories using tested models to validate trades and strategies. They price quotes slightly off true market value, then readjust bid and ask prices as markets move, ensuring smooth operations without glitches or erratic price moves.

Why Crypto Markets Need Market Makers More Than Traditional Finance

Crypto markets differ fundamentally from traditional exchanges. They operate 24/7 with no settlement times and global access. Exchanges are fragmented with vastly different trader pools.

Crypto markets frequently list new coins and tokens, creating extreme volatility. All listed assets are directly available for retail trading, making liquidity and order books increasingly unpredictable.

As a result, crypto markets lack the established liquidity infrastructure of traditional finance. Instead, steady liquidity must be provided externally and engineered by market makers.

How Market Makers Make Money

Market makers have incentives to provide liquidity through spread capture—placing slightly different ask and bid prices. This allows them to buy lower and sell higher, with the spread serving as their fee.

Due to high trading volumes, market makers typically receive fee discounts or pay no trading fees. They trade at lower fees compared to market takers, who only absorb existing orders.

Many market makers build their own low-latency trading systems, expanding tools for their operations and other market makers. Professional market makers operate across multiple venues, including centralized and decentralized exchanges, capturing arbitrage opportunities and price inefficiencies between platforms.

Earnings require high-volume trading capabilities. Since spreads offer thin margins, market makers make relatively small gains per trade and must carefully track inventory to propose optimal orders and spreads.

The Exchange-Market Maker Relationship

Exchanges and market makers share a symbiotic relationship. Exchanges provide the platform while market makers supply liquidity. Consequently, exchanges offer incentive tiers based on trading fees, with market maker fees always lower than market taker fees.

Exchanges also provide special liquidity provision periods with enhanced incentives. Some head-tier exchanges operate native liquidity programs with reduced or zero fees. Market makers may earn rebates and gain access to performance reports and statistics, plus low-latency access for efficient trading.

Exchanges offer preferential conditions to professional liquidity providers. While numerous market makers exist in various sizes, a handful of professional providers are typically selected for key market pairs. New listings often depend on market makers receiving token allocations and providing two-sided liquidity.

Centralized vs Decentralized Market Making

Market makers operate through both centralized exchanges and decentralized trading ecosystems. On centralized exchanges, they use order book technology to place orders.

On DEXs, market makers deposit passive liquidity—typically stablecoins or two-sided liquidity—earning yield though facing impermanent loss risks. They can also actively trade and place orders, benefiting from aggressive strategies and spread profits.

DEXs haven’t eliminated market makers but changed their liquidity provision possibilities and tools. Market makers are often first participants in newly launched token pools, frequently through team partnerships.

When Market Makers Pull Liquidity

Market makers are everyday participants, but traders notice them during dramatic market events. Volatility spikes are common in crypto, and market makers can exacerbate volatility by withdrawing liquidity.

Market makers attempt to profit while avoiding losses. Volatility spikes create risks of asset losses. Some market makers employ algorithmic protections adjusting quotes based on inventory levels and market volatility.

News shocks or risky trading can quickly trigger market maker algorithms, causing correlated risk-off behavior and position shutdowns across multiple markets. Market makers reduce inventory exposure during market stress periods, often leading to asset breakdowns with no apparent correlation.

For traders, this translates into flash crashes causing anomalous pricing far outside usual trading ranges. Total liquidity withdrawal can cause assets to fall to zero before recovering based on remaining orders.

Market makers can also cause bid-ask spread ‘blowouts,’ deliberately widening typically tight spreads to protect against significant losses. This means traders often don’t see expected order fills.

Are Market Makers Manipulating Prices?

Market maker activity can lead to deep, anomalous crashes. Traders often accuse market makers of deliberately crashing prices and exacerbating volatility.

Manipulation requires proven intent, not yet established for market makers. Normal market reactions and algorithmic triggering can resemble deliberate one-sided price moves. Rarely, some market makers offer one-sided liquidity causing crashes, yet under normal conditions, they react to news without creating directional moves.

While exchanges incentivize market makers, they don’t incentivize directional moves. These incentives don’t imply intent. Though some whales act directionally, exchanges curate market makers expecting stabilizing behavior. Rogue market makers failing to provide stability are typically removed.

Narratives from various sources can trigger trader reactions, and market maker activities may be misunderstood as inventory protection algorithms aren’t always transparent.

How Market Makers Shape Price Discovery

Market makers track inventory under varying conditions. Reference prices determine market ranges through formulas serving as DEX activity bases.

Formulas determine prices based on token availability on each trading pair side. More tokens deposited lower the price; more stablecoins raise it. Reference prices move along curves, though some exchanges offer concentrated liquidity at predetermined, narrower ranges.

With low-latency access across multiple markets, market makers make trades shifting prices toward cross-exchange alignment. Small price differences trigger quick arbitrage, equalizing prices.

Market maker activity is the primary reason crypto asset prices converge globally with only brief price disparity episodes. Crypto markets achieve efficiency despite fragmented liquidity, increasing credibility by reducing mispriced assets and significant price differences.

What Retail Traders Misunderstand About Market Makers

Traders often blame market makers during volatile price swings, claiming they deliberately place orders triggering stop-loss orders. However, market makers don’t determine price direction but position themselves based on general market movements.

Market makers focus on tight spreads and inventory management. While they influence prices through liquidity provision, they make no directional bets, instead choosing neutral strategies earning from spreads.

Market makers don’t always win. They sometimes withdraw liquidity avoiding big losses and take inventory risks, remaining vulnerable to impermanent loss and general trading risks. Their behavior is required by their role, with incentives to trade this way, benefiting from spreads, low latency, and reduced fees.

Why Market Makers Are Becoming More Important in Crypto

Cryptocurrency trading increasingly attracts institutional participation and ETF trader inflows. Markets are growing derivative and options trading volumes. These market structures require price stability guarantees.

Market makers ensure fewer erratic price movement moments and available liquidity within reasonable ranges. Lacking liquidity results in more volatile prices and impossible order-matching.