Market Maker Insider: The Industry is Wild, "Order Book" Spread and Options are Key Profit Drivers

Original Article Title: "About Market Maker | Project Team's Dark Forest Self-Rescue Guide"

Original Article Author: Maxxx, Head of Metalpha Ecosystem

A confession from a frontline Market Maker, a dark forest self-rescue guide for project teams, hoping to be of some help to you :)

Allow me to introduce myself: I'm Max, a post-00s who feels very old, originally a struggling finance student in Hong Kong, but has been in the crypto world since 2021 (thanks for saving the industry). Although my time in the industry is not long, I initially entered as part of a project team, then later started my own ventures in developer communities and accelerators, always in close proximity to frontline entrepreneurs. Now, I am in charge of our Market Maker business line at @MetalphaPro, thanks to the boss for the opportunity, giving me the title of Head of Ecosystem, but in reality, I handle BD and sales. Over the past year or so, I have worked with @binance, @okx, @Bybit_Official, and second-tier exchanges, handling listings and market-making for a dozen or so coins in total, gaining some shallow experience.

Recently, amidst a tumultuous spring, the topic of Market Makers is in the spotlight. I have always wanted to systematically discuss the unique role of Market Makers in the industry, and I took the opportunity to organize some thoughts. I may not be an expert in this field, so I ask for forgiveness for any oversight. This article only represents my own views and is 100% from my own hands. If you find it helpful, please consider liking and sharing to help this laborer meet their KPIs. Thank you.

Starting from the GPS "Observation Tag"...

I heard that Binance had placed a "watch tag" on GPS. At that time, I was chatting with a project founder whom I had known for over a year and who planned to list in Q2. This young and capable founder appeared tired during our conversation. The project had raised a few million, achieved some good results, everything seemed to be going smoothly, but the funds raised by the founder were actually debt. After more than a year of continuous pivoting, amidst the tough market conditions, they were trying to close a new round of funding while struggling to negotiate with mainstream exchanges, watching as tokens one after another plummeted in price, worrying about how to explain to investors. Only friends who have gone through a project can understand the bitterness, worry, and confusion. Just as we were deep in conversation, Binance's notice suddenly caught our eye. Although we had not cooperated with the project on market making, coincidentally, we had been in contact with some team members for the past two years. In an instant, we were filled with emotion.

Regarding this matter, I will not analyze or comment too much. Gossip is annoying, so let's wait for Binance and the project team's official notification and announcement. However, over the past two years, I have indeed seen too many project teams and retail investors being pitifully rug pulled by market makers. It just so happened that I took this opportunity to write this article, hoping to help project teams and industry friends. Alright, enough chit-chat, let's get to the point.

Market Maker Business Model: Not as Magical as Rumored, Just a "Order placer"

Market maker is not a new term in crypto. It also exists in the traditional financial industry, but this service has a more straightforward name, called Greenshoe (because in 1963, the Green Shoe Company in Boston, USA, used this mechanism for the first time during an IPO). Although the mechanism is slightly different, the responsibilities are generally the same, which is to make both buy and sell orders during an IPO to maintain market liquidity and relatively stable prices. However, due to strict compliance regulations, the Greenshoe business is a set of very standard trading desk sideline services with not much room for maneuvering, and not a single major exchange would proudly announce that they are conducting this particular business. Paradoxically, this standard business has become a godlike entity for many in the crypto industry, seen as a scythe that controls the market.

However, if market makers really adhere to industry norms and provide liquidity in a regulatory manner, there is no need to talk about any "scythe." The so-called liquidity provision mainly involves making bids on both sides of the order book. Of course, in the broader sense, market makers in the crypto industry have other categories and business models, but today we will only focus on the most relevant one that serves project tokens. This narrower category can be broadly categorized into several business models:

Active Market Maker

In fact, much of the demonization of market makers in the industry comes largely from the presence and actions of active market makers in the early days of the industry. There is a Cantonese saying "doing the kitchen," or in Mandarin "running the bank," active market makers fulfill the market's every fantasy about market makers. Generally, active market makers cooperate with projects to directly manipulate market prices, pump and dump, and profit from it, harvesting retail investors, and sharing the gains with the project. The terms of their cooperation vary, involving borrowing coins, accessing APIs, leveraging, profit-sharing, and other models. There are even rogue market makers who do not communicate with the project team, directly use their own funds to rush into the market, manipulate the market after accumulating enough chips.

Which active market makers are in the market?

Actually, the market's active market makers who are active in PR, event organization, and relatively well-known are all passive market makers, or at least they must claim to be, to avoid compliance issues, let alone flaunting their marketing activities (but it cannot be ruled out that some market makers may have engaged in some active cases in the early days of the industry or are currently engaging in secret activities).

Most active market makers are very low-key and do not have a public presence because they are not compliant. As the industry gradually standardizes, previously high-profile entities like ZMQ and Gotbit have been named by the FBI and faced serious compliance issues. The remaining active market makers have become more secretive, with some of the larger ones having participated in so-called "successful cases" and thus having a certain "reputation." Most deals are also made through referrals from acquaintances.

Passive Market Makers

Passive market makers, including ourselves and many other peers, fall into this category. They mainly engage in providing liquidity to the market by placing maker orders on both sides of the order book on centralized exchanges. The business model is mainly divided into two types:

· Token Loan

· Retainer (Monthly Fee)

Token Loan Model

This is currently the mainstream and most widely adopted partnership model. In essence, it involves lending coins to market makers for a certain period, who in turn provide market-making services.

A typical token loan deal consists of several aspects:

· Loaned Amount x%: Usually a percentage of the total token supply

· Loan Term x Months: The duration of the loan, with services ending upon maturity, and settlement based on a pre-negotiated option

· Option Structure: The market price at which the service ends

· Liquidity KPI: The depth of the market maker's order book, potentially across different exchanges and price ranges

How do market makers make money in this model?

Market makers earn money in two main ways: firstly, from the spread between buy and sell orders during order book placement, which is generally a small portion; secondly, from the options granted by the project team, which typically represent a larger portion.

If you are familiar with finance, you may know that the value of an option on the day it is signed is significant. This value is a percentage of the borrowed coin's value. For instance, if I borrowed a total of 1 million units of a coin, and the option's initial value is 3%, then strictly following an algorithm (delta hedge) to place orders would potentially result in a relatively certain profit of $30,000. Under normal circumstances (extreme market movements such as a skyrocketing or crashing price where efficient delta hedging is not possible), the revenue from this collaboration would be $30,000 plus some profits from the spread during order placement.

Do you feel like liquidity providers are not making as much profit as you thought? But in reality, the profit margin I mentioned is not completely detached from reality. Liquidity providers are currently also very active, and competitive option prices are increasingly transparent.

Retainer (Monthly Fee Model)

This is currently the second relatively mainstream model, which refers to the project side not lending the token to the liquidity provider but keeping it in their own trading account, and the liquidity provider provides liquidity through API access. The advantage of this model is that the token remains in the project side's hands, and all operations in the trading account are transparent to the project side. In theory, the project side can withdraw funds from the account at any time, so there is no need to worry about the risk of the liquidity provider acting maliciously. However, in this model, the project side needs to prepare tokens and U in the account for two-sided liquidity provisioning, and generally, they need to pay the liquidity provider's service fee monthly.

In this case, the liquidity provider provides liquidity based on the client's liquidity KPI, earning the service fee each month. The funds in the account are unrelated to the liquidity provider. In extreme cases of poor liquidity or front-running, the liquidity provision may result in losses, and these losses are borne by the project side.

I believe that Token Loan and Retainer each have their own advantages and disadvantages. Some exchanges only focus on one of them, while others, like us, can do both. The project side should choose according to their needs and the project's situation.

Several Common Misconceptions

Liquidity providers are responsible for "pumping," "price manipulation," and "wash trading."

A qualified passive liquidity provider is neutral and does not actively participate in pumping, market manipulation, or exploitation.

Liquidity providers providing liquidity is synonymous with "volume faking."

Exchange order books have two types of orders: maker orders and taker orders. Passive liquidity providers mainly place maker orders, and the taker order proportion is minimal. Even with deep maker orders on the order book, if there are no takers from the counterparty to match, it does not directly increase the trading volume. However, if a participant trades against their own maker order, known as "self-trading," there are compliance risks. Leading exchanges also closely monitor such behavior, and if the self-trade proportion is too high, both the liquidity provider's account and the token could face warnings and actions from the exchange.

So, it sounds like passive liquidity providers are useless?

Not directly responsible for the coin price, not directly responsible for the trading volume, it sounds like it, but it's useless. However, good liquidity is the foundation of everything. Small-volume money cares about the coin price trend, while large capital wants to enter, the first thing they look at is the trading volume and depth. An actively traded token with a healthy price and the project's product strength and marketing ability are closely related and indeed require close cooperation with market makers. Stepping back, even top-tier exchanges rarely list a project without a professional MM; otherwise, the opening will most likely be a mess. MMs need to register in advance, so at this stage, cooperation with passive market makers is still a step that every project listing on a top-tier CEX must go through.

It sounds like market-making is just placing orders, and the threshold is not high, so can projects do it themselves?

Yes and no. If you do have a proprietary trading team, and the project is relatively large, some second-tier exchanges may allow you to do it yourself. But if you don't have one, or need to build a team from scratch, I suggest leaving the professional work to the professionals. On the one hand, the cost and risk of building a team are not as good as finding a reliable market maker; on the other hand, if you are not familiar with MM, placing orders yourself can really lose a lot of money in the face of various extreme market conditions.

Market Maker's Ecological Position: Opening liquidity is the most valuable resource

After explaining the business model, let's talk about the current situation, which may help you understand better.

What will the crypto space look like in 2024-2025?

From a liquidity perspective, this is how I see it:

· BTC has an independent market trend, rising all the way, with sufficient top-tier liquidity. There has been a recent pullback, but it does not shake the foundation. Miners are happy as mining costs are in the 5 to 6 digits, and traditional institutions entering the space are also happy.

· Fierce battle in the tail end, liquidity was once relatively sufficient. @pumpdotfun, @gmgnai, @solana, @base, and @BNBCHAIN have seen young traders losing money addictively (I have also contributed a bit, damn it), outliers and insiders have also made money happily.

· Drying up of liquidity in the mid-range, reaching its peak with trump and libra, sucking almost dry the liquidity and buying interest of the mid-range, and structurally irreversibly moving from inside the circle to outside. Tokens with market caps of hundreds of millions to tens of billions are in an awkward position. Tokens newly listed on first and second-tier exchanges have no buyers, and within two months of listing, trading volume drops sharply. Most of the trading volume and depth occur at the opening, quickly dropping below the VCs' primary price. When VCs unlock, they will most likely lose money, and when team tokens unlock, they will most likely go to zero.

This cycle, these mid-cap tokens seem to be having the worst time. But another harsh reality is that over 90% of the so-called "web3 native" professionals in our industry, who are truly the ones receiving and spending wages, attending meetings, conducting business on a daily basis, including VCs, project teams, accelerators, business development, marketing, developers, and so on, everyone is doing business with mid-cap tokens. If you look at fundraising, product development, marketing, community engagement, and listing on exchanges, this series of activities actually revolves around these mid-cap project teams listed on centralized exchanges. Therefore, in this cycle, many professionals have not made money, and times have been tough for everyone.

Only market makers, in my opinion, hold the scarcest resource of mid-cap tokens: "Listing Liquidity." Yes, having liquidity alone is not enough; liquidity needs to be there early, right at listing, because once the project goes to zero, having more tokens on hand is useless. A project with, for example, a 15% circulating supply at listing offers 1 to 2 percentage points, or even more, to market makers. This liquidity, unlocked right at listing, is an extremely valuable resource in the current market conditions. Therefore, not only are market makers becoming more crowded, but many VCs and project teams are also stepping in to temporarily form teams and start market making. Some teams may not even have basic trading abilities, but they take the tokens first, as they will end up at zero anyway and are not afraid of being unable to cash out.

The Dark Forest of Gresham's Law: Honest Contribution-Based Character Can't Beat the "Scoundrel"

In the evolution of this market scenario, we have formed a very unique ecosystem for market makers today:

On one hand, market makers are increasing, and quoting has become absurdly competitive. On the other hand, there is a huge disparity in service quality and professional capabilities, often resulting in various after-sales issues, with the most common being draining liquidity and defaulting to dump the price. Firstly, it should be clear that market makers are not prohibited from selling tokens. In fact, if a token skyrockets, following the algorithm to place sell orders is necessary because the borrowed tokens need to be returned, and the settlement with the project team is in USD (for those who do not understand, please review the section on token loan options again). However, a qualified passive market maker should place orders normally according to the algorithm, rather than aggressively taking liquidity from the order book. Such actions are extremely harmful to the project.

Why do market makers do this?

Going back to the part we just talked about regarding options, a market maker who has received a token loan can place orders according to the algorithm. If the market remains stagnant, he should successfully realize the value of the option and earn 3%. However, if he believes that the project will go to zero at settlement, he can achieve a 100% return by aggressively dumping at listing, which is essentially 33 times the return of normal market making. Of course, this is the most direct and extreme example, and most real-world operations will be much more complex. However, the underlying logic is to short the token, sell during high prices and good liquidity, and buy back on settlement.

Of course, aside from being unethical and non-compliant, there are additional risks to this approach. On one hand, the market maker is completely unable to provide liquidity according to the KPI within the contract period because they lack a healthy inventory. On the other hand, if the token takes a wrong turn, a lot of money can be lost with no way to cash out.

Why is this behavior so common?

In the end, the industry's compliance is still in its early stages. Regarding the token loan model, although the market maker will report to the project party on the service situation through daily reports, weekly reports, dashboards, and other means, there are third-party supervisory organizations and tools in the market. However, what the coin does in the market maker's account is ultimately a black box, and the market lacks effective regulatory measures. After all, the only conclusive evidence that can see each trade made by the market maker is the centralized exchange itself. However, many market makers are clients of centralized exchanges' V8 and V9, bringing in hundreds of millions of dollars in fees and liquidity to the exchange each year. The exchanges also have an obligation to protect the privacy of their clients, so how could they possibly disclose the details of their trades to help the project party enforce their rights?

At this point, one cannot help but admire @heyibinance and @cz_binance for their swift actions. In my impression, this is the first time the complete trading details of a market maker have been publicly disclosed, including precise times, operational details, and cash-out amounts. Whether such behavior should be done is worth considering, but the original intention must be good.

Both the project party and the entire industry need to strengthen their understanding of market makers. Actually, I am very surprised that I have talked to many top-tier investors, founders of projects that have raised tens of millions of dollars, and even industry practitioners, and they do not have much understanding of the market maker profession. This is also a significant reason why I wrote this content. Because most project parties are actually experiencing this for the "first time," while market makers are battle-hardened "bad boys."

As a frontline practitioner, sometimes when I see the project party choosing the so-called "better terms," I also ask myself if I am matching the outrageous terms offered by competitors to secure the deal first. In this dark forest of market makers, it is difficult to hold the bottom line. Therefore, pretending to be a profound bad boy will always be more attractive than being an honest person. Only when everyone's understanding of the industry aligns can we avoid the continued occurrence of bad money driving out good.

How to Choose Your Market Maker

There are several important questions and tips that I believe are key:

Is Passivity Always the Wrong Choice?

Actually, when the project party asks me this question, I will not outrightly say that passive market makers should not be chosen. If we set aside compliance, I believe this is a debatable issue. Some projects have indeed achieved a better-looking chart, more trading volume, and more cashouts through close collaboration with passive market makers, with countless instances of overspending. At this point, I only express one viewpoint: you need to realize that those who can really bring you tangible benefits will also definitely cut you mercilessly. And there is only so much liquidity in the market. At the end of the day, you are on opposing sides, and the market's money will either be earned by you or by your passive market maker.

Which Collaboration Method to Choose: Token Loan or Retainer?

Currently, the token loan model is still more mainstream, but the market share of retainers is gradually increasing. This is a matter of project team preference and needs. For example, a project team with strict fundraising controls may be unwilling to have uncontrollable large-scale liquidity from external sources. Additionally:

Try Not to Choose Only One Passive Market Maker

Don't put all your eggs in one basket. You can choose 2-4 market makers, compare terms with each other, and have backups in case one goes down. Furthermore, market makers usually propose various additional value-adds to win the deal. Selecting multiple market makers can get you help from more people. However, to avoid the "three monks have no water to drink" problem, it is recommended to allocate different exchanges to different market makers, as monitoring them together can significantly increase the complexity.

Don't Choose Your Market Maker Solely Based on Investment

You can accept investments from market makers, and having more runway is always good. However, you also need to understand that market maker investments and VC investments are not playing the same game. As market makers control a considerable portion of the opening liquidity, they can lock prices, hedge, and perform other operations on the tokens they have yet to unlock from their investments. Therefore, for the project team, it may not always be a good thing that a market maker holding a token loan also has a significant portion of their token investment position.

Don't Choose Your Market Maker Solely Based on Liquidity KPIs

It is challenging to thoroughly verify liquidity KPIs in practice, so do not select a market maker solely based on liquidity KPIs. Terms may look good on paper, but if they cannot be delivered, they are useless. Before lending the tokens, you are in control, but once you lend them to the market maker, you become dependent on them. They have many ways to deceive you.

Change Your Mindset: Be a "Scumbag" Yourself

Remember, you are the first party. Before signing any agreements, compare terms thoroughly and discuss extensively how to monitor and prevent market maker defaults. Choose a solution that suits your project's development. You can use one party's terms to pressure the other, compare back and forth, ensure there is no ambiguity in the terms, and if something is unclear, don't speculate, ask directly.

A Little Reflection

I am a newcomer to the industry and I deeply cherish the opportunity to perceive and engage with the industry at this level. I often feel the industry's dirtiness and chaos, but I also constantly sense its vitality and energy. I never consider myself the smartest in the bunch; many of my peers in the industry are excellent, quickly finding their own position. However, more young people are actually lost without the web3 industry, making it hard to find a path to success.

I also have a boss with extremely positive values and a highly skilled trading team working in the background. Our stable asset management business allows us to support the team without relying on market-making business, using the market-making business to make friends instead. I have always followed my own pace, using the logic of making friends with the project teams, missing out on some deals, but also proud of a few deals I've closed. Although some projects didn't turn into business deals, I have also become friends with the project teams.

I have rambled on a lot. I was very conflicted about posting this article. On one hand, I'm afraid of not being knowledgeable enough about the business or not expressing myself well, potentially misleading the project teams and readers. On the other hand, market makers have always been elusive in the industry, and I'm afraid of not handling the disclosure properly and intruding on someone's territory.

However, I truly believe that as the industry evolves, compliance will gradually become mainstream, and one day, the role of market makers will no longer be demonized. They will return to the spotlight. I hope this article can have a small impact.

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