Everything you need to know about market makers

Nov 8, 2021 | Foundations, Trading

When investors trade digital currency, there’s a good chance they aren’t trading with another individual or institutional investor. Many orders go through market makers. If you want to know what market makers do, keep reading. 

What do market makers do? 

The role of a market maker is to make the market efficient. They provide liquidity in markets by posting buy and sell prices on various trading platforms. It may help to compare their role to a car dealer. While you could buy or sell a used car independently, making the deal will take time. It’s not always easy to find the person selling the car you want or to line up a buyer who wants your car. Many people prefer to sell to a dealer for a little less or buy from a dealer for a little more to save time. 

Digital asset markets work similarly. There may or may not be someone willing to buy or sell when you place the trade. You might want to buy at $99, but the only seller wants to sell at $101. Your options are to wait or to change your order price. 

How do market makers make money? 

Market makers make money by buying a few cents cheaper than the price at which they later sell an asset. If they can get just a few cents off each share traded and do that on millions of shares per day, their profits quickly increase. Here’s how: The market maker may think the market price is $100. If the seller is willing to go down to $99.75, but you aren’t willing to come up, the market maker will buy from the seller at $99.75 and aim to sell to someone else for $100 within a few hours, minutes, or even seconds – and so profit from market changes.  

The market maker could be wrong on individual trades and not find a buyer or seller at a profit, but they commonly use advanced computer analysis to make sure they get things right more often than not. 

 

How do market makers help investors? 

Market makers provide additional availability of digital currencies and narrow bid-ask spreads  although they sometimes widen when the market is uncertain.  The bid-ask spread is the difference between what the buyer and seller are offering each other. This makes market makers especially useful for lesser-known currencies. 

With a trading volume of over US$50 billion in 24 hours, Bitcoin wouldn’t necessarily need market makers. There is enough volume to keep the bid-ask spread small. Market makers track coins and trade when they think they can profit off the spread and sit out when they can’t. 

Divi, ranked 196th among digital currencies by market cap, only has about US$150,000 in trading volume per day. As a relatively small volume, this can make it hard for investors to pair up. If you entered a market order, you might be taken advantage of by sellers and buyers. A seller might hope you’ll overpay, and a buyer might hope you’ll sell low just to make the trade now.  

Another question is, why might investors trade with a market maker now at a lesser price instead of waiting for a regular investor? Fair question. Investors may view trading with a market maker as insurance against the price getting even worse. Let’s say the last trade was $100 with prices trending up, and a market maker offered to sell at $100.25. If an investor’s buy limit is $100 and prices keep going up, they may need to adjust their order to even higher than $100.25 or miss buying altogether. 

Market makers provide a service to ensure that there is always someone willing to buy and sell in the market. For that service, they earn a bid/ask spread. In difficult markets, this spread may be wider but with strong competition, it rapidly converges to an efficient market consensus price.

Stephanie Baxter, Head of Global Markets, Fabriik 

What is an automated market maker? 

Market making uses a significant degree of automation – in the form of algorithmic trading – where market making buys and sells trades often happen just seconds apart. But, there is still a human overseeing the algorithms and making adjustments. 

An automated market maker operates purely by algorithms. The automated market maker may run through a human market maker. Other automated market makers let individual investors deposit their coins to give the market maker liquidity, and in return, those investors receive a portion of the market maker’s trading profits. 

 

What about market manipulation? 

It’s true. There have been cases where market makers have manipulated markets to inflate or deflate prices. Usually, this can only happen when there is a very low trading volume, or the exchange doesn’t have a good order flow. 

Most of the time, other market makers know the actual market value and look to keep the spread narrow. Market makers profit more from a larger spread but have to work to keep the spread down because they are competing with each other for investors. 

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