Complete Guide to Crypto Market Making: How Web3 Founders Can Find the Right Market Maker?
Crypto Market Making Guide: Finding the Right Market Maker for Web3 Founders
The opaqueness and complexity of cryptocurrency market making can be daunting, but ensuring liquidity is crucial for the growth and stability of token economies.
This report reveals the state of cryptocurrency market making, providing practical insights for founders looking to work with market makers (MMs). Key considerations include assessing whether your project needs an MM, criteria for selecting an MM and contract negotiation.
Our research insights are supported by real project agreements, quant finance and market making experts.
An Introductory Guide to Market Making
Market making involves an institution or trader quoting both a buy (bid) and a sell (ask) price for a security or asset, in order to provide market liquidity. The bid price represents the highest price a buyer is willing to pay for a security, while the ask price represents the lowest price a seller is willing to accept for the same security. The difference between the bid and ask prices is called the spread, which represents the market maker’s profit margin.
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Market makers are typically incentivized to maintain tight spreads and provide liquidity to the market, as this attracts more buyers and sellers, leading to increased trading volume. In turn, higher trading volumes increase the market maker’s profits.
Liquidity refers to the ease with which an asset can be bought and sold without affecting its price. Markets with high liquidity have many buyers and sellers, so there is always someone willing to buy or sell an asset. In contrast, markets with low liquidity have fewer buyers and sellers, which can lead to large price swings when someone wants to buy or sell a large amount of assets.
OK, so now that we know what market makers are, where’s the problem?
The problem is that the short-term profit goals pursued by market makers may not align with the project team’s pursuit of long-term value creation. Our goal is to help founders form synergistic relationships with market makers, avoiding transaction structures that allow market makers to benefit at the expense of sacrificing long-term project goals.
Do you need a market maker?
Founders should first consider two questions:
1. Does my project need a market maker at this stage?
Market makers are typically needed in the early stages of a project’s listing, such as during an initial exchange offering (IEO) when initial trading volume is close to zero. Established digital assets typically have sufficient market-supplied liquidity, making market making less beneficial.
2. What benefit does working with a market maker bring to my project?
In other words: Does my protocol need liquidity? Liquidity could be crucial for a decentralized finance (DeFi) protocol designed for high-volume trading. Conversely, liquidity may not be as critical for a governance token designed for slow holding.
In the latter case, a simple 50/50 Uniswap pool or other decentralized liquidity pool may suffice. Setting up a liquidity pool can be a simple DIY solution and requires less funding than hiring a market maker who charges recurring service fees. Once the protocol develops to a certain degree (for example, reaching hundreds of thousands or millions of daily active users), the project can be moved to a centralized exchange such as Binance, Huobi, or Crypto.com.
Evaluating the Pros and Cons
When conducting a cost-benefit analysis, founders should consider their specific situation, including financial status, project timeline, and token use case:
1. Narrow spreads: Narrowing the bid-ask spread makes trading more attractive and lowers transaction costs for both buyers and sellers. Tight spreads ensure minimal fees and slippage, providing a better trading experience.
2. Liquidity begets more liquidity: Initial liquidity fosters more liquidity, attracting more buyers and sellers to enter the market (“liquidity begets liquidity”), creating a cycle that further amplifies trading volume and liquidity.
3. Price discovery: A highly liquid market aids in accurate price discovery, representing the true value of an asset based on the decisions of numerous market participants.
4. Price stability: High liquidity can reduce sharp price fluctuations from large orders, enhancing investor confidence. To maintain the project’s long-term vision, users ideally price the token based on its intrinsic utility and value rather than purely as a speculative asset (which can happen when prices fluctuate highly).
1. Participation fees: Market makers may need to set up fees, recurring fees, or token borrowing. For example, GSR, a leading cryptocurrency market maker, charges a setup fee of $100,000, recurring fees of $20,000 per month, and provides loans of $1 million in Bitcoin and Ethereum.
(Block unicorn note: Setup fees typically refer to one-time fees that market makers need to pay before they start providing market making services to founders or project parties after signing contracts. This may include fees that market makers need to create and configure trading strategies, as well as fees for other preparatory work for project market making.
Recurring fees typically refer to fees that market makers need to pay regularly (such as monthly or annually) while providing market making services to projects. This may include fees that market makers need to maintain and manage trading strategies, as well as fees for providing ongoing market making services to projects. These fees are usually fixed and unrelated to the actual amount or value of transactions that market makers trade.)
2. Imbalanced transactions: Due to their low trading volume (small profit for market makers), founders or token issuers are usually in a weaker negotiating position. In this case, market makers can take advantage of this to force more skewed transactions.
3. Bad actors: The lack of regulation in the cryptocurrency industry may attract fraudulent market makers who engage in fraudulent activities, such as brush orders or abuse of token loans. The risk of damage that may be caused by improper behavior or default of market makers should be considered.
Criteria for choosing market makers for tokens
There are currently more than 50 major market makers in the cryptocurrency/web3 field. When choosing market makers, we recommend referring to the following 5 key criteria:
1. Cost: Including the sum of setup fees, recurring fees, performance-based fees, and option fees.
2. Capability (trading volume and spread): The initial quote trading volume or spread provided by market makers. Market makers may only guarantee quotes during certain hours of the day, while some market makers can trade around the clock.
3. Reputation: Mature companies with a large balance sheet, a good track record (such as cooperation with reputable projects, traditional financial experience), and experience in delta-neutral market making.
4. Accessibility: the standards set by the market maker itself when choosing the trading market (for example, market makers with a minimum trading volume threshold for assets).
5. Cooperation: reliable contacts with major exchanges (Binance, Huobi, Crypto.com), which may help with exchange listings, must be considered carefully and conservatively.
Market Maker Contract Terms
The final step is negotiating and finalizing a contract outlining the terms of the market making agreement, also known as a liquidity consulting agreement (LCA).
By analyzing public and private market making agreements, we identified key factors in the agreements that any project founder should be aware of:
We consider compensation to be any form of financial incentive meant to reward positive behavior by market makers. We identified three main forms of compensation from multiple market making trades: 1) service fees, 2) options, and 3) fees based on key performance indicators (KPIs).
A fixed fee paid to the market maker may be a significant fiat currency for early-stage projects. There are several pricing structures:
1. Set fee: A one-time lump sum payment made to the market maker at the start of the service contract.
2. Retainer fee: Fees paid to the market maker on a regular basis (e.g. monthly, biweekly, quarterly) – this is usually a specified fixed rate.
3. Both a set fee and a retainer fee (retained market making services).
4. No charge: In a bull market, market makers may choose not to charge any form of fee, especially for popular tokens. The supply-demand dynamics determine the cost of the entire market making, and speculative tokens provide enough profit for market makers without further charging.
Founders should be aware that market makers typically have a negotiating advantage, for reasons including:
Rich market options: Market makers can trade in many different markets, so losing a trade pair to a project has limited business impact for them.
Limited profit margins for early-stage projects: For early projects with limited existing trading volume or liquidity in their native tokens, market makers see limited profit opportunities and potential risks when providing services. Market makers profit from high-frequency algorithmic trading, so when trading volume is limited (lack of liquidity), this opportunity is less attractive to market makers.
Options are common in market-making agreements, and are represented by token prices providing financial return to the market maker. Typically, this gives the market maker the option to purchase tokens at a pre-agreed price upon loan maturity.
Thus, market makers have an incentive to keep prices above a certain threshold (the exercise price of the option), since this gives them the ability to exercise the option to buy a certain number of tokens at a pre-specified exercise price, and immediately sell them at the higher current market price, making a considerable profit.
Market makers use options to persuade founders to sign agreements with them, indicating that using options can align them with the success of the token (i.e., its price increase). This is particularly common in bull markets, where tokens from early projects can increase in value by 100x, and market makers work harder to secure option trades (and often succeed).
However, these options become worthless after expiry, and this alignment is always short-term for market makers.
Using options as a reward for market makers is complex and risky for the following reasons:
1. Pricing challenge: Determining a reasonable exercise price, option period, or volatility for a new asset is extremely difficult and prone to significant inaccuracies. In bull markets, market makers aim to negotiate huge option packages at low prices, to gain returns from token price increases in a way that is similar to venture capital.
2. Manipulation risk: For founders with limited financial/statistical knowledge, they may become victims of manipulation of key parameters of option value. They may not even be aware that the options they provide have an attached price/implied value – similar to the difficulty of valuing equity in a startup company.
—Unethical market makers can underestimate the actual value of the options by using unrealistic assumptions in their calculations, leading to founders unintentionally giving up more value. This can be achieved by using unreasonable assumptions (such as token volatility being equal to Bitcoin volatility), which means that the option value in the contract is actually significantly lower than it should be.
Special note: While token founders don’t need to study complex statistics and options pricing theory, there are tools that can be used to roughly estimate the value of token options in contracts. It is difficult to determine the exact value of your options trades, but founders should understand the value provided so they can have more transparent and wise discussions with market makers.
There are tools and methods that can be used to estimate the value of options, such as calculators or simulators based on options pricing models. Founders can use these tools to generate a rough valuation range so they can better understand the value of options. However, it is important to note that these valuations are only for reference and the actual value of options may be influenced by a variety of factors, including market conditions, project development, and market maker motivation.
Founders should strive to understand the value of options trades and have a more transparent and wise stance when discussing with market makers. This can better protect the long-term interests of the project and ensure a relatively fair and profitable agreement with the market maker.
We have created a basic tool to assist in estimating and valuing option contracts: Blockingperclip Option Pricing Tool
There may be a risk of price manipulation:
1. If the option price is too high, this will encourage market makers to push up prices.
2. If the option price is too low, market makers (if the loan repayment model is based on token quantity) can maximize profits by shorting tokens, ultimately only needing to repay part of the principal.
One available form of option pricing is to use “tranches,” in which the token issuer provides several option choices with different exercise prices or expiration dates. For example, GenesysGo, which signed a contract with Alameda, offers three tranches priced at $1.88/$1.95/$2.05 option exercise prices.
Interestingly, tranches have almost no substantive impact on actual services. Nevertheless, they exist for two reasons: a) market makers want to make the transaction more complicated, making it appear more “legitimate.” b) Market makers may want to offer slightly better transaction terms than their competitors.
Performance-based fees can be created using key performance indicators (KPIs) to reward market makers for achieving the expected goals of a project. Here are some performance indicators (and our evaluation of them):
1. Trading Volume
Trading volume as an indicator carries significant risk, as it may incentivize wash trading. This practice is illegal in most markets and can lead to misleading market data by artificially inflating trading volume numbers.
As an indicator, it is not ideal, as it may lead market makers to artificially inflate token prices, which can subsequently pose risks of ecosystem collapse when prices fall back down.
a. The spread or bid-ask spread is the difference between the quoted prices for immediately selling and buying stock. In other words, it is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to sell.
b. Generally, this is a relatively reliable key performance indicator, though it requires supplements with indicators capturing market depth (otherwise, the spread may be small but prices are easily swayed).
4. Minimum buy and sell order size (in USD)
a. The minimum buy and sell order size refers to the value in USD (project token value) that market makers are willing to buy and sell.
b. This is an important key performance indicator that ensures there is reasonable buffer when large orders cause significant price fluctuations, preventing prices from skyrocketing or collapsing easily.
Comparing different forms of compensation
Deciding which form of compensation to choose in a project is ultimately highly personalized and depends on the founder’s funding situation, goals for decentralization and governance, and the stage the project is at.
Visualization of Compensation Mechanisms: In terms of “deterministic” or “average cost” metrics, fees generally have higher determinism (represented in USD value) than options, but may spike significantly depending on market conditions. However, in a bull market, if the underlying token price skyrockets, subscription options can easily inflate to very high values.
Service fees (including setup fees and monthly recurring fees) are a balanced arrangement, but may require high initial costs to increase liquidity support from well-known market makers (MM) for the project. However, it is not ideal to set vague goals for these fees. Combining performance-based fees with specific goals, such as price spreads, can better align market maker behavior with project goals. However, it should be noted during negotiations to avoid using easily manipulated KPIs, such as transaction volume.
— We recommend that risk-averse teams combine service fees with KPI-based bonuses. Cash-strapped projects should look for proven and reliable small and medium-sized market makers, while well-funded projects should contract with large top-tier market makers and negotiate primarily on a fixed-term basis.
Compensating through options may result in overpayment for market maker services and increase risk. Another negative result involves governance: if founders issue a large number of options to market makers at a low exercise price, market makers may accumulate a large amount of circulating supply. This damages the decentralization of the agreement, especially since market makers tend to vote for profit maximization rather than alignment with the project’s vision.
— For cash-strapped but high-risk-tolerant teams, it may be possible to use a certain number of options in the incentive plan, but the present value of the options should be noted. However, if the project has a substantial cash reserve and a loyal user base, the use of options is generally not recommended and thorough scenario testing is necessary to avoid overpayment.
Here is a summary of the above content:
A framework for understanding market maker trading risks is: as a founder, consider what market makers will gain or lose if project token prices increase 1,000 times or drop to zero.
Assuming that market makers always act with the goal of maximizing profits and returns, the team should be able to understand the market maker’s motivation to drive prices. Ideally, market makers should have a neutral attitude towards price trends, as their goal is only to provide liquidity.
In a market-making agreement, a common arrangement is for the asset issuer or the party requesting liquidity services to provide loans to the market maker for token trading and liquidity provision. Several key elements of the loan terms are important:
1. Loan term: The length of the loan term is important because it determines how long the project needs to wait before the market maker returns the loan capital. This should be negotiated on a case-by-case basis based on the project roadmap and the financial needs of the core team.
2. Interest rate: This token loan is based on a 0% interest rate because the market maker receives variable returns when trading. It is not attractive to pay fixed interest.
3. Token loan amount and value: If the token used in the loan is consistent with the ecosystem’s native token, the incentive consistency will be stronger. However, it should be noted that loans based on token amounts have a disadvantageous incentive for market makers, as they will benefit if the token price falls because the value of the repayment amount will decrease. This contractual term is similar to “embedded options” because it brings significant potential benefits of a major drop in price to market makers before the maturity date.
4. Repayment issues: The project party should specify the contractual obligations that will arise if the market maker cannot repay the token. The contract terms usually include payment of the outstanding amount in BTC/ETH or stablecoins.
1. Notice Period
Normally, both parties can terminate the agreement by written notice within a certain period of time in advance. As with many commercial agreements, the notice period for termination is usually between 14 and 30 days. However, each issuer should evaluate the difficulty of obtaining additional market makers based on their individual circumstances and adjust the notice period accordingly. Other conditions under which both parties can terminate the agreement.
2. Asset Issuer
a. Has the right to terminate the agreement in the event of a material breach of its obligations.
Market maker: Market makers have more important termination rights because they decide on the conditions for no longer providing liquidity. We outline four possible termination conditions and comment on key considerations for the core team (if applicable).
1. Default on payment terms: the issuer should ensure that safeguard measures are in place, including grace periods, to provide the team with a buffer time in case of poor financial conditions.
2. Other contract breaches (e.g., confidentiality agreements).
3. Conflict with the terms and regulations of the exchanges providing liquidity.
4. Legal regulations: due to the constantly changing regulatory environment of the cryptocurrency field, market makers need to protect themselves against the sudden criminalization of their obligations. One source of potential legal due diligence is to understand the legalities of market making in traditional asset markets, which can establish a precedent for future Web3 regulatory approaches.
In most liquidity protocols with market makers, market makers are typically exempt from any responsibility related to token price fluctuations. This is expected since cryptocurrencies have speculative nature. It should also be noted that there are countless factors beyond the control of market makers that can determine the price of tokens, so it is fundamentally unreasonable to ask market makers to bear the financial consequences of such price volatility.
In summary, market making plays a critical role in ensuring liquidity and stability in the cryptocurrency market. This report is intended to reveal the complexity of cryptocurrency market making and provide actionable insights for founders considering partnering with market makers. Through analysis of real contracts and insights from industry experts, this report emphasizes the necessity of considering market makers, choosing the right company, and negotiating terms.
We hope this report will be a valuable resource for founders and other stakeholders in the cryptocurrency ecosystem, helping them make wise decisions in market making and driving growth and stability in the token economy.