So, LO:TECH was going to write a piece on why token projects need good market makers. We’re a trading firm we thought, we do liquidity provision, we make markets. And we’d like to help projects as they bring their token to the masses, hoping to be the next Ethereum. A well written piece to expand on the important role of a market maker, why they are essential for young exchange listed tokens, is a great idea, we thought.

But.

But, but, but, we’ve also been in this space for a decent amount of time, and we know that back in 2018 Evgeny Gaevo, CEO of Wintermute, wrote this very piece - and it’s a fantastic article. Although slightly dated now, written as it was in the height of the ICO boom, it covers off all the main points about why good market makers are vital to the success of exchange-listed token projects:

• Exchanges will be much more accommodating to token projects that have engaged with a professional market making business as part of the listing process and for ongoing liquidity
• Investors and community members will be better served by tighter trading spreads and higher volumes which, in turn, attract more sophisticated investors
• Better trading metrics (liquidity) raise the profile of tokens, further generating interest in the project and driving more trading activity

Perfect. So there’s nothing left for LO to write on this topic? Time for a cuppa?

Well, not quite. In the 6 years since Evgeny’s article was written, there’s been quite an evolution in the crypto market making space. So many new entrants, from well-funded TradFi spin-offs, to one-person crypto native shops, offering a range of market making services from plain vanilla liquidity provision through to the straight-up dubious. Taken in this context, some of the big things the original article doesn’t touch on are what type of market maker a project should look to engage with, and what a token project should demand from their market maker when they do sign up to a liquidity provision agreement. As a build on the original article, we’re going to explore some of these ideas below.

Understanding what type of market maker a project should choose, and what they should demand from them, presupposes that those doing the choosing have a very good understanding of what it is that a market make it does; what service it is they provide.

The original article explains this well. Market makers - through the orders they place into the order book - provide potential counterparties with immediacy of execution and risk transfer. Said more plainly, they are there to take the other side when other people want to trade. And they should be there, in your token’s order book (potentially on multiple exchanges), almost all the of time, with a good amount to trade against, so that when that new investor you have been courting begins to buy up your tokens they can do so smoothly and with low trading costs.

Understanding this outline of what it is that a market maker actually does should help a token team begin to appreciate what they need to look for when assessing potential providers. Managing multiple orders in real time, potentially across many venues and staying risk neutral as trading activity occurs, is a highly technical undertaking. All of this activity - and the associated risk and balance management - should be conducted algorithmically.

As such, token teams should be looking for market makers who can point to, and demonstrate, their technical trading sophistication. With more and more important trading activity occurring on DEXs and AMMs, this sophistication should extend beyond just centralised venues to onchain as well. These sorts of technical chops are naturally found in algorithmic and high-frequency crypto trading firms, where this type of activity is part and parcel of regular business activity. Token teams should look for firms that are technology-first, and who are open about how they use that technology for the benefit of their market making clients. They should be prepared to give details and specifics when asked. If a firm is hand-wavy when pressed on this, it’s definitely a red flag. There have been plenty fly-by-night pseudo market making shops set-up in the last few years that do not have the technical capability to fulfil their obligations - asking to see systems running and for demonstrations is a must to root these out.

Something else it is important to understand, and which will help a team make a better provider choice - market makers don't set the price in the order book. As liquidity providers, they tend to have very little directional exposure to a particular token’s price. And, other than for the overall health of a project, they don't (shouldn’t) really mind if the price goes up or down.

Understanding this gives another clue to help choose a partner: if any provider begins to talk about price management or gives you price appreciation or volume targets, walk away immediately. It is not the job of the market maker to set the price of a token or guarantee an amount of trading volume; this will be done by the overall demand and supply dynamics for your token. If you want the price to perform well, this is token team’s job. Execute on the road map, build a community and deliver value - price appreciation will come. Liquidity providers that promise “price pumps” are potentially engaging in behaviours that are very dubious from an exchange rules and regulatory perspective, and should be avoided at all cost - there be dragons.

Instead, KPIs for market making deals should focus on metrics that reflect the quality of the liquidity the market maker provides. These indicators should include maximum bid-offer spread, total liquidity at a specified depth(s), and up-time guarantees, at a minimum*.* Token teams would do well to work with the type of firm that is keen to put these in place and open about being measured against them.

This last point again highlights the importance of choosing a partner that is open, honest and keen to give transparency to their clients around the quality of the service they are providing, backed up by technology that works. As a high-frequency trading business, we’ve had a number of token projects ask us to analysis the activity in their order books where their contracted market makers are supposed to be providing liquidity. Unfortunately, in many cases the results are shocking, with clear evidence that the providers are not sticking to their contracted obligations, despite what they purport in their weekly “reports”.

But this shouldn’t need to happen - a token project shouldn’t get to the point where they have to engage a third party to investigate whether their market maker is behaving. They should be provided with the tools see that the obligations are being met in real-time, so there is no doubt they are getting the service for which they paying good money.* If a firm is technically capable of making markets for your token across multiple venues, then they should be able to at least provide a token team with a live dashboard showing their activity.

All this, comes back to the same two points: token projects should look for technological sophistication and transparency when selecting a market making provider. Even without the involvement of clients, market making trading strategies have characteristics that are similar to a ‘service’. The market maker provides passive liquidity for others to execute against and they get compensated by retaining bid offer spread. As clients are added into the mix, and market makers actually begin to provide a paid for service then the client has every right to demand the tools to see that the service is being well provided and having the desired effect.

If you are a token project looking to partner with an open and transparent, forward-thinking market maker, please reach out to the team.

*Keep an eye out for our next mm-focused article, which discusses how token projects should pay their market maker