As in any market for products or services, cryptocurrency prices are shaped by the crossover between bid and ask. The traders involved in the exchange, who personify and create these two levers of commerce, are market makers and market takers.
In this article, we will talk about the players and mechanisms behind the seemingly simple operation of digital currency exchanges.
Who are market takers
Once a buy order is opened and it corresponds to an existent seller warrant in the order book, it becomes a «market taker», from the English word «take». The term itself implies that you accept someone’s offer and therefore «taking» the appropriate fluid from the order book.
Market takers, in contrast to market makers, attach more value to the order’s instant fulfillment rather than its conditions. This is why in most cases you will not see the taker’s position in the order book, as most inexperienced participants are executing market orders. Unlike limit warrants, such orders are filled at the earliest possible available cost.
What is a market maker and how do they work?
Well, whenever you enter a trade that doesn’t correspond to an available bid (demand cost) or ask (supply cost) in the order book, then you are becoming a «market maker» because you create a new trade by increasing the amount of market size. Market makers typically attempt to purchase at the lowest cost and sell at the highest cost.
Market makers: what they do and why they are important
Regardless of whether a market maker receives remuneration from their client, the majority of their profits come from the spread. This means that market makers will enter trades at various prices in the current spot market, similar to the case below:
A market maker opens a bid position at €3,100 and a ask position at €3,000. While the market value is still in this range, the market maker will receive margin which is represented by the spread.
By ensuring market fluidity by doing so, market makers are helping to guarantee that there’s someone always available to purchase or sell digital currency at any given moment. Ensuring that liquidity, meanwhile, enhances one’s depth of market, which is the capacity to absorb big offers with no increase in the asset’s volatility.
To know whether market deepness is high, just examine an exchange’s depth chart. If it is going high, the graph will display big coloured fields representing the sums involved in the buy and sell limit orders.
The entry of a «whale» (a major holder of cryptocurrencies) into such a market will not be as negative as in an illiquid market, as there will be many more orders matching the supply or demand of the «whale» in a liquid market. The reciprocal volatility will be low, so market makers are essential to the healthy marketplace.
But market making carries risk as well, as a market maker may find themselves in a situation where they have a large amount of cryptocurrency on hand, but aren’t making a return if there aren’t buyers or sellers at perfect values.
That’s the reason why pros or market makers typically hedge their positions and customers by using hedge trading strategies. To control positions and making the business become more lucrative, they invest significantly in tech like artificially intelligent in order to automate these transactions.
The difference between a market maker, broker, dealer and arbitrageur
Market makers are frequently mistaken for market brokers, traders, dealers or arbitrageurs. Really, what they all have one thing in common is participation in the digital financial market as well as trading. Virtually all of them make money on the spread, but what differentiates them is how they do it.
The primary goal of a trader is not to make money on the spread, but to invest and speculate on the value of an asset using a variety of strategies. The fundamental difference between a trader and a market maker is that a trader doesn’t seek to supply the market with liquidity.
Stock brokers are middlemen who transact in different types of financial tools on investors’ names. They might utilize their access to major liquidity to operate as market makers, but this isn’t their primary activity. Brokers, like exchanges, can also be customers of market makers.
Dealers are a category that includes market makers because they are external providers of market liquidity. The distinction between a trader and a market maker is that the first one offers its services on an ongoing base, whereas the second one chooses to offer its services in each case.
Lastly, the distinction between market making and arbitrage is that the purpose of arbitrage is not to provide liquidity or volume, but to profit from price differences between different marketplaces.
AMM: what does an automated market maker do?
Cryptocurrency exchanges typically use two models in their operations: order book or AMM.
AMM means «automated market maker» and it is a decision made in the context of DeFi, designed to render decentralized exchanges (DEX) autonomous from conventional market makers.
In this type of exchange, transactions and liquidity are managed automatically through smart contracts and input from the participants itself. In effect, everyone can contribute liquidity and get rewarded for it. Let’s take a look at how this is done.
On DEX, every exchange pair for example ETH/USDT is linked to its own liquidity pools, in which both currencies of the pair are escrowed and blocked according to a fixed ratio. From these pools, the necessary liquidity for trade is scooped up. Everyone can supply liquidity in exchange for a commission per trade, so there is no requirement for market makers, who can be met on centralized marketplaces.
In situations of lower liquidity and higher volatility, the automated engine is also balancing the supply of coins in the liquidity pool of the pair: fluid is deleted or supplemented until the divergence from the better bid value to the better ask value is progressively rebalancing to the standard market position.
The situation of market volatility, if identified at an early stage, opens up possibilities that are very much in demand by traders utilizing arbitrage scenarios. Besides the fact that this activity is beneficial for the latter, it provides the exchange with volumes and assists AMM in bridging the demand-supply gap that occurs naturally.
Summarize
Market makers and market takers have a decisive part to play in the fast-paced realm of crypto trading. Market makers ensure liquidity and contribute to the smooth operation of the market by continually indicating supply and demand costs, whereas market participants execute trades by accepting these quoted prices. Both participants contribute to the overall efficiency and stability of digital currency markets.
Market makers benefit from spreads and transaction fees, while market takers benefit from immediate execution. Understanding the roles and interactions of market makers and market takers is important for traders and investors looking to successfully navigate the world of cryptocurrencies.
