What is a market maker?
Key points
- A market maker is a market participant that trades an asset within pre-agreed ranges of price and volume to support orderly demand on markets.
- Its main function is to shape supply and demand by taking part in trading directly. In doing so it creates a live market, prompting investors and traders to transact.
- A market maker can be a specialist firm, such as a bank or broker, or even an individual. In financial markets, market makers operate officially and openly, in line with the law and exchange rules. They may be hired by exchanges or by companies keen to improve the efficiency of trading in a specific asset.
Why do markets need a market maker?
When a new asset starts trading on an exchange — for example, shares after an IPO — its price can be unstable. Herding behaviour and a lack of liquidity can trigger sharp price swings, falling volumes and wide gaps between buying and selling prices.
To avoid this, a trading venue or issuer may retain a market maker. This is a special participant, typically a large organisation with substantial capital and a team of professional traders.
The aim is to make the market more efficient by tackling the following:
- Creating liquidity. The market maker must supply the exchange’s clients with enough of the asset to keep orders flowing. That lets investors and traders execute orders of various sizes at different prices. For example, a market maker may commit to quote both buy and sell orders in a given asset equal to $1m from 10:00 to 15:00 every trading session for a month.
- Preventing abrupt price swings. The market maker should keep prices moving continuously and smoothly, damping sudden drops and spikes. It watches that the spread — the gap between buy and sell — is kept to a minimum.
- Intermediating large trades. If liquidity is thin, executing a large order at once can destabilise the market. To avoid that, the market maker can arrange the trade off-exchange, acting as an intermediary between a big buyer and seller.
How do market makers operate and earn money?
Unlike traders and investors, a market maker does not rely solely on price moves — its revenue streams are broader. Examples include:
- Spread. The market maker keeps the difference between Ask and Bid, known as the spread. For example, the current selling price (Ask) is $99.5 and the buying price (Bid) is $100.5. The market maker posts orders on both sides of the book and ultimately earns the $1 difference when trades are executed.
- Arbitrage. Like other large players, market makers exploit market inefficiencies by deploying various arbitrage strategies.
- Fees for services. A market maker may receive a fixed fee from an exchange or another interested party, as well as bonuses and trading discounts.
- Over-the-counter deals. Acting as a go-between for large buyers and sellers, a market maker can earn a percentage for facilitating such transactions.
How do market makers affect the cryptocurrency market?
On traditional financial markets, the biggest market makers are large investment banks: Citi, Barclays, Bank of America, Goldman Sachs, JP Morgan and Morgan Stanley.
In crypto, major market makers include Alameda Research, affiliated with the FTX exchange, and trading firm Cumberland.
Growing activity in 2021 boosted demand for stablecoins used for settlement and capital storage. According to information published by Protos in August 2021, Alameda Research and Cumberland accounted for around 70% of USDT issuance at the time.
Market makers earn by providing crypto exchanges with liquidity for USDT trading pairs (BTC/USDT, ETH/USDT and the like), as well as by brokering large over-the-counter deals.
According to Protos, Cumberland is most active on Binance, while Alameda Research works with FTX.
What role do market makers play in DeFi?
The mechanisms used on centralised exchanges also suit the market for DeFi applications. One of the largest market makers in DeFi is Jump Crypto, the crypto arm of Chicago trading giant Jump Trading.
Alongside market-making on decentralised exchanges such as Serum, running on the Solana blockchain, Jump Crypto invests heavily in DeFi. A few portfolio highlights:
- Orderly Network. A decentralised exchange on the NEAR blockchain raised $20m from Three Arrows Capital, Pantera Capital, Dragonfly Capital, Sequoia China, Jump Crypto, Alameda Research, and several other firms.
- Metaplex. A platform for creating NFT tokens and applications on the Solana network raised $46m in a round led by Multicoin Capital and Jump Crypto.
- 0x Labs. A DEX-infrastructure provider raised $70m in a Series B funding round led by Jump Crypto and Jared Leto.
- Certora. A developer of tools for analysing smart-contract security raised $36m in a Series B round from Jump Crypto, Tiger Global and Galaxy Digital.
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