What is Market Making?
Market Makers are the invisible hand driving financial markets by providing balance and stability. For investors, knowledge about market Makers is important to understand financial markets and to make informed investment decisions.
What is a market Maker?
Market Makers are typically institutions that are tasked to facilitate the smooth trading of an asset increasing liquidity of that asset and cushioning prices from potential volatility caused by supply and demand.
In the crypto space, centralized exchanges use market Makers to increase liquidity and reduce price dislocation. While decentralized exchanges primarily use Automated Market Makers, they can use Market Makers too.
In market making operations, speed and technology are important to provide seamless liquidity for buyers and sellers. Automated algorithms are often used by market Makers to optimize trading activity and ute trades based on predetermined rules. These algorithms are often proprietary as they are coded and fine-tuned by the respective market Makers. The combination of financial expertise and an efficient algorithm allows market Makers to be responsive to ever-changing market conditions.
In this article, we’ll explain how market Makers improve market stability through facilitating liquidity and how better liquidity facilitates price discovery and price stability of an asset.
Understanding liquidity
The role of a market Maker is to increase liquidity of an asset. Liquidity simply refers to how easily you can buy or sell an asset without impacting the price.
● In a highly liquid market, plenty of buyers and sellers are present. It should be easy to find someone to trade with at a reasonable price within a relatively short period of time.
● In an illiquid market with few buyers or sellers present, prices offered may not have anyone accepting it for a prolonged period of time unless the price is much higher than the previous price offered.
So, liquidity is critical for a trading environment to be attractive to investors. This is the main reason why projects hire market Makers.
Better liquidity facilitates price discovery and price stability of an asset
When it comes to price discovery, the two main forces are supply and demand. Market Makers help facilitate both supply and demand forces to help provide an agreeable price for both buyers and sellers. This helps to cushion the forces of supply and demand and allow an asset price to stabilize at the appropriate market level.
Let’s say there is an asset called Token X. The market for Token X is not liquid, meaning there are only a handful of buyers and sellers.
● If an institution decides to buy up a large amount of Token X, demand for the limited supply of tokens left on the market increases sharply, causing prices to spike.
● On the other hand, if the institution decides to sell their entire stash of Token X - this would flood the market, increasing supply significantly. If there aren’t enough buyers to absorb this demand, the price of Token X will drop sharply in response.
Volatility can increase the level of uncertainty and risk in the market, making it harder for investors to make informed decisions and deploy capital effectively.
Therefore, a market Maker is important to help bring balance and stability to the changing market conditions.
In the next part of this series, we will explore the inner workings of market making.
Disclosure: This article was written in partnership with DWF Labs, a market Maker and Gate.io institutional client. For more information on DWF Labs, visit www.dwf-labs.com
