The Myth of Getting Rich in the Cryptocurrency Market exists every day. Most players come here not to double their money, but to turn their fortunes around. In this dark forest, cryptocurrency market makers, as the top predators closest to the money, are becoming increasingly mysterious.
Price manipulation, pumping and dumping, and taking advantage of the unaware are synonymous with cryptocurrency market makers. However, before we label them with these “negative” terms, we need to recognize the important role they play in the cryptocurrency market, especially for early-stage listing projects.
Against this backdrop, this article will explain what market makers are from the perspective of Web3 project teams, why we need market makers, the DWF incident, the main operating models of cryptocurrency market makers, and the risks and regulatory issues they face.
I hope this article will be helpful for project development and I welcome discussion and exchange.
1. What are Market Makers?
Citadel Securities, a leading global hedge fund, defines market makers as playing a crucial role in maintaining market liquidity. They achieve this by simultaneously providing buy and sell quotes, creating a market environment with liquidity and market depth that allows investors to trade at any time, injecting confidence into the market.
Market makers are essential in traditional financial markets. In Nasdaq, there are an average of about 14 market makers for each stock, totaling about 260 market makers in the market. In markets with lower liquidity than stocks, such as bonds, commodities, and foreign exchange markets, most trades are conducted through market makers.
Cryptocurrency market makers refer to institutions or individuals who provide liquidity and buy/sell quotes for projects in cryptocurrency exchange order books and decentralized trading pools. Their main responsibility is to provide liquidity and market depth for trades in one or more cryptocurrency markets, and profit from market fluctuations and supply-demand differences through algorithms and strategies.
Cryptocurrency market makers not only reduce trading costs and improve trading efficiency but also promote the development and promotion of new projects.
2. Why do we need Market Makers?
The main goal of market making is to ensure that the market has sufficient liquidity, market depth, and stable prices, injecting confidence into the market and facilitating trade. This not only lowers the entry barrier for investors but also incentivizes them to engage in real-time trading, which in turn brings more liquidity, forming a virtuous cycle and creating an environment where investors can trade with confidence.
Cryptocurrency market makers are particularly important for early-stage listing projects (IEOs) because these projects need sufficient liquidity, trading volume, and market depth to maintain market activity/awareness and promote price discovery.
2.1 Providing Liquidity
Liquidity refers to the ease with which an asset can be quickly sold without depreciation, describing the extent to which buyers and sellers in the market can buy and sell relatively easily, quickly, and at low cost. High liquidity markets reduce the costs of any particular transaction and facilitate trade formation without causing significant price fluctuations.
Essentially, market makers facilitate faster, larger, and easier buying and selling of tokens for investors at any given time by providing high liquidity. This allows investors to operate without interruption or impact from significant price fluctuations.
For example, if an investor needs to buy 40 tokens immediately, they can buy 40 tokens at a price of $100 each in a high liquidity market (Order Book A). However, in a low liquidity market (Order Book B), they have two options: 1) Buy 10 tokens at $101.2, 5 tokens at $102.6, 10 tokens at $103.1, and 15 tokens at $105.2, with an average price of $103.35; or 2) Wait for a longer period of time for the tokens to reach the desired price.
Liquidity is crucial for early-stage listing projects, and operations in low liquidity markets can affect investor confidence and trading strategies, indirectly leading to the “death” of projects.
2.2 Providing Market Depth and Stabilizing Token Prices
In the cryptocurrency market, most assets have low liquidity and lack market depth, and even small trades can cause significant price changes.
In the scenario mentioned earlier, after the investor just bought 40 tokens, the next available price in Order Book B is $105.2, indicating a price fluctuation of about 5% from a single trade. This is especially true during market volatility, and fewer participants can cause significant price fluctuations.
Market makers, on the other hand, provide a large amount of liquidity, leading to a narrow bid-ask spread in the order book. A narrow bid-ask spread is usually accompanied by solid market depth, which helps stabilize token prices and mitigate price fluctuations.
Market depth refers to the available quantity of buy and sell orders at different price levels in the order book at a given moment. Market depth also measures the ability of an asset to absorb large orders without significant price changes.
Market makers bridge this supply-demand gap by providing liquidity, playing a crucial role in the market. Imagine which market you would prefer to trade in:
The role of cryptocurrency market makers: 1) providing a large amount of liquidity; 2) providing market depth to stabilize token prices. Ultimately, this enhances investor confidence as every investor wants to buy and sell their assets in real-time at the lowest trading cost.
3. Who are the Major Players in Cryptocurrency Market Making?
Market making can be considered one of the top businesses in the food chain, as they control the fate of project tokens after listing. Market makers usually work with exchanges, making it easy for them to form a monopoly, with a few major market makers dominating the market’s liquidity.
In July 2023, Worldcoin, a cryptocurrency project co-founded by OpenAI’s Sam Altman, reached agreements with market makers when it officially launched. It lent a total of 100 million $WLD tokens to five market makers to provide liquidity and specified that the borrowed tokens must be returned after three months or bought at a price ranging from $2 to $3.12 per token.
These five market makers include:
A. Wintermute, a registered company in the UK, with notable investments in projects such as $WLD, $OP, $PYTH, $DYDX, $ENA, $CFG, and more, having invested in over 100 projects since 2020.
B. Amber Group, founded in 2017, is a Hong Kong-based company with a board of directors that includes distributed capital, among other well-known institutions. The team consists mainly of Chinese faces. They participate in projects such as $ZKM, $MERL, $IO, and more.
C. FlowTraders, founded in the Netherlands in 2004, specializes in providing global digital liquidity for exchange-traded products (ETPs) and is one of the largest ETF trading companies in the European Union. They have created exchange-traded notes based on Bitcoin and Ethereum and conduct cryptocurrency ETN trading.
D. Auros Global, involved with FTX, filed for bankruptcy protection in the British Virgin Islands in 2023, with $20 million in assets stuck on FTX. News of a successful restructuring has emerged.
E. GSR Markets, founded in the UK in 2013, is a global cryptocurrency market maker that specializes in providing liquidity, risk management strategies, programmatic execution, and structured products for mature global investors in the digital asset industry.
4. The DWF Controversy
DWF Labs, the most popular “internet-famous” market maker in the market recently. DWF’s Russian partner, Andrei Grachev, founded DWF in Singapore in 2022. The company claims to have invested in a total of 470 projects and collaborated with approximately 35% of the top 1000 tokens by market capitalization in its short 16-month history.
Let’s review the events:
4.1 Exposé
On May 9, The Wall Street Journal reported that an anonymous source claiming to be a former insider at Binance revealed that Binance investigators discovered $300 million worth of fraudulent trades by DWF Labs in 2023. An individual familiar with Binance’s operations also stated that Binance did not require market makers to sign any specific agreements governing their trading behavior, including prohibiting market manipulation.
This means that, to a large extent, Binance allowed market makers to trade as they pleased.
4.2 DWF’s Market Promotion
According to a proposal document sent to potential clients in 2022, DWF Labs did not adhere to price-neutral rules but instead proposed using its active trading positions to boost token prices and create so-called “artificial trading volume” on exchanges, including Binance, to attract other traders.
In a report prepared for a token project client that year, DWF Labs even directly stated that it successfully generated artificial trading volume equivalent to two-thirds of the token and was working on creating a “believable trading pattern” that, if partnered with DWF Labs, could bring “bullish sentiment” to the project token.
4.3 Binance’s Response
A Binance spokesperson stated that all users on the platform must comply with the general terms of use prohibiting market manipulation.
A week after submitting the DWF report, Binance fired the head of the monitoring team and laid off several investigators over the next few months, attributing it to cost-saving measures.
Binance co-founder He Yi stated that Binance has always monitored market makers and is very strict. Market makers compete with each other using dark tactics and may launch PR attacks against each other.
4.4 Possible Reasons
On the Binance platform, DWF is the highest level “VIP 9,” meaning DWF contributes at least $4 billion in monthly trading volume to Binance. Market makers and exchanges have a symbiotic relationship, and Binance has no reason to offend one of its largest clients for the sake of an internal investigator.
5. The Main Operating Models of Cryptocurrency Market Makers
Like traditional market makers, cryptocurrency market makers also profit from the spread between buying and selling prices. They set upLow buy-in price, high sell-out price, and profiting from the price difference, this difference is usually called the “Spread”, which is the main basis for market makers’ profits.
After understanding this basis, let’s take a look at the two main business models of market makers for project parties.
5.1 Subscription Service + Trading Commission (Retainer + Performance Fee)
In this model, the project party provides tokens and corresponding stablecoins to the market maker, and the market maker uses these assets to provide liquidity to the CEX order book and DEX pool. The project party sets KPIs for the market maker based on its own needs, such as an acceptable price difference, the need to ensure market liquidity and depth, etc.
A. The project party may initially give the market maker a fixed setup fee as a start for the market-making project.
B. Afterwards, the project party needs to pay the market maker a fixed monthly/quarterly subscription fee. The basic subscription fee is usually $2,000/month or more, depending on the scope of services, with no upper limit. For example, GSR Markets charges a setup fee of $100,000, a monthly subscription fee of $20,000, plus a $1 million BTC and ETH loan.
C. Of course, some project parties may also pay KPI-based trading commission fees to incentivize market makers to maximize profits (incentives for market makers to successfully achieve KPI goals in the market).
These KPI metrics may include trading volume (which may involve illegal wash trading), token price, buy-sell spread, market depth, etc.
In this model, the market-making strategy is clearer and more transparent, making it easier for project parties to control. It is more suitable for mature project parties that have already built liquidity pools in various markets and have clear goals.
5.2 Token Loan + Call Option (Loan/Options Model)
The most widely used market maker model in the market is the token loan + call option model. This model is especially suitable for early listing project parties.
Due to limited funds in the early stages of listing, project parties find it difficult to pay market-making fees, and there are fewer circulating tokens in the market in the early stages of the project. In this case, it is more suitable for market makers to set KPIs based on the project’s situation. To compensate market makers, project parties usually embed a call option in the market-making contract to hedge the token price risk.
In this model, market makers borrow tokens (token loan) from the project party to ensure liquidity and stablecoin prices in the market, usually with a market-making period of 1-2 years.
The call option allows market makers to choose whether to purchase the borrowed tokens from the project party at a predetermined price (strike price) before the contract expires. It is important to note that this option gives market makers the right to choose, not an obligation.
The value of this call option is directly related to the token price, providing market makers with the motivation to increase the value of the tokens. Let’s simulate a scenario:
Let’s assume that the Mfers project has found a market maker and signed a call option, agreeing to lend 100,000 tokens with a strike price of $1 and a term of 1 year. During this period, the market maker has two choices: 1) return the 100,000 Mfer tokens at maturity; or 2) pay $100,000 (at the $1 strike price) at maturity.
If the token price rises 100x to $100 (yes, Mfers to the Moon), the market maker can choose to exercise the option, buying tokens worth $10,000,000 for $100,000 and making a profit of 100 times. If the token price falls by 50% to $0.5, the market maker can choose not to exercise the option ($100,000) and directly buy 100,000 tokens at the market price of $0.5 to repay the loan (worth half of the strike price, $50,000).
Because of the existence of the call option, market makers have the motivation to create a frenzy of buying to increase the value of the tokens. At the same time, there is also the motivation to create a frenzy of selling to buy at a low price and repay the loan.
Therefore, in the token loan + call option (loan/options model) mode, project parties may need to consider market makers as counterparties and pay special attention to:
A. The strike price and the amount of token loan received by the market maker, which determine the market maker’s profit space and market-making expectations.
B. Pay attention to the loan period, which determines the market-making space in this time dimension.
C. The termination clause of the market-making contract and the risk control measures in case of emergencies. Especially after lending tokens to market makers, project parties cannot control the whereabouts of the tokens.
5.3 Other Business Models
We can also see that many market makers have first-level investment departments, which can better serve invested projects through investment and incubation, providing services such as fundraising, project promotion, and listing. Owning shares in invested projects also helps market makers reach potential clients (investment and lending linkage?).
OTC over-the-counter trading is similar, purchasing tokens at a low price from project parties/foundations, and using a series of market-making operations to increase the value of the tokens. There is more gray area in this regard.
Sixth, Risks and Regulations
After understanding the operating models of cryptocurrency market makers, we know that besides their positive impact on the cryptocurrency market, they not only exploit retail investors but also project parties. Therefore, project parties need to grasp the risks of cooperating with cryptocurrency market makers and the obstacles that regulations may bring.
6.1 Regulation
In the past, regulation of market makers was focused on “securities” market makers, and the definition of cryptocurrency assets is not yet clear, which has resulted in a relative regulatory blank for cryptocurrency market makers and market-making activities.
Therefore, for cryptocurrency market makers, the current market environment is a situation where the sky is high and the birds fly freely. The cost of misconduct is very low, which is why they are synonymous with price manipulation, pumping and dumping, and exploiting retail investors.
We see that regulations are constantly being standardized. For example, the U.S. SEC is clarifying the definition of Broker & Dealer through regulatory enforcement, and the introduction of the EU MiCA regulation also includes market-making business in regulation. At the same time, compliant cryptocurrency market makers actively apply for regulatory licenses, such as GSR Markets applying for a major payment institution license from the Monetary Authority of Singapore (allowing OTC and market-making services within the regulatory framework of Singapore), and Flowdesk, which completed a $50 million financing at the beginning of the year, obtaining a licensing application from the French regulator.
However, the regulation of major jurisdictions does not prevent some cryptocurrency market makers from operating offshore because they are essentially large capital accounts in various exchanges, and most of them do not have any onshore business.
Fortunately, due to the FTX incident and the continuous regulation of major exchanges such as Binance and Coinbase, cryptocurrency market makers coexisting with exchanges will also be restricted by the internal control and compliance rules of the exchanges, making the industry more standardized.
We do need regulation to standardize these unethical/illegal behaviors, but before the industry explodes, we may need the industry to embrace the bubble.
6.2 Risks
Due to the lack of regulation, cryptocurrency market makers have the motivation to engage in unethical trading and market manipulation to maximize profits, rather than having the motivation to create a healthy market or trading environment. This is also the reason why they have a notorious reputation and bring various risks.
A. Market Risk for Market Makers
Market makers also face market risk and liquidity risk, especially in extreme market conditions. The collapse of Terra Luna and the collapse of FTX have led to a chain reaction that resulted in a comprehensive failure of market makers, the collapse of leverage, and the depletion of market liquidity, with Alameda Research being a typical representative.
B. Lack of Control over Loaned Tokens for Project Parties
In the token loan model, project parties lack control over the tokens lent and do not know what market makers will do with the project’s tokens. It could be anything.
Therefore, when lending tokens, project parties need to consider market makers as counterparties, rather than partners, and think about possible scenarios due to price impact. Market makers can achieve various purposes by adjusting the price, such as deliberately suppressing the price to set a lower price for a new contract or voting anonymously for proposals that benefit them, and so on.
C. Unethical Behavior of Market Makers
Unethical market makers manipulate token prices, exaggerate trading volumes through wash trading, and engage in pumping and dumping. Many cryptocurrency projects hire market makers to use wash trading and other strategies to improve performance indicators. Wash trading refers to the repeated trading of the same asset by entities to create the illusion of trading volume. In traditional markets, this is illegal market manipulation that misleads investors’ demand for specific assets. Bitwise published a famous report in 2019, stating that 95% of trading volume on unregulated exchanges is fake. A recent study by the National Bureau of Economic Research (NBER) in December 2022 found that this number has dropped to around 70%.
D. Project Parties as Scapegoats
Due to the lack of control over the tokens lent and the difficulty in restraining the unethical behavior of market makers, or even knowing about these unethical behaviors, project parties may be held responsible if these behaviors fall under the scope of regulation. Therefore, project parties need to pay attention to the terms of the contract or emergency measures.
Seventh, Conclusion
Through this article, project parties can gain a clear understanding of how cryptocurrency market makers contribute to liquidity, efficient trade execution, enhanced investor confidence, smoother market operations, stablecoin prices, and reduced trading costs.
At the same time, by revealing the business models of cryptocurrency market makers, this article highlights the various risks that may arise from cooperation with market makers, and project parties need to pay special attention when negotiating terms and executing cooperation with market makers.