All about Liquidity: How Crypto Exchanges Work with Market Makers

-by 1Token BD Team

Prelude

Crypto exchange is the core player in the cryptocurrency & digital asset market that combines multiple roles in traditional finance, with diversification to compete with each other.

How do crypto exchanges attract more users and excel from the competition? The competencies can be trading pairs, trading cost, security, liquidity, UI/UX, earn… Among which liquidity is one key factor that institutions would consider when choosing crypto trading venues.

What is liquidity?
To understand what liquidity is, the most straightforward metric is the expected slippage. It is the difference between the current market mid-price and the average price from actual ution. The key factors behind this are the spread (the difference between the bid and ask price) and the depth (the amount of buyers and sellers available at various prices ).

Imagine which order book below you would prefer to trade on

Similarly, in a cryptocurrency exchange, liquidity means buying and selling efficiently in terms of time and cost. A highly liquid cryptocurrency exchange will have many buyers and sellers of each cryptocurrency listed on the platform, allowing traders to enter and exit positions with minimal price slippage.

For instance, these are the order books for BTC/USDT on CEX1 and CEX2 at the same point in time. We can see that buying 16.982 BTC on CEX1 will lead to approximately a slippage of 6.055 USDT (0 taker fee on CEX1) and buying 15.897 BTC on CEX2 will lead to a slippage of 1.528 USDT (0.02% taker fee on CEX2), meaning that CEX2 has higher liquidity in BTC/USDT than CEX1 at this particular moment.

Comparison of BTC/USDT liquidity on CEX1 and CEX2
1.0 taker fees BTC spot trading pairs on CEX1
2.Take the lowest spot taker fee on CEX2 (0.020%)

For exchanges that want to achieve higher liquidity, a common practice is to enlist the services of market makers.

What Is a market maker?
A market maker is an entity or an individual that provides liquidity by continuously placing limit orders on both bid and ask.
In TradFi (forex, stock, ETF markets, etc.), market makers are those big brands like Goldman Sachs, Two Sigma, Citadel…
In the crypto market, crypto market makers fall into two categories:

● TradFi high-frequency trading firms expanding into the cryptocurrency market and becoming market makers: Jump Trading, Tower Research, DRW Cumberland.
● Crypto native firms that grow to become market makers: B2C2, Wintermute.

Crypto exchanges like Gate.io, Bitfinex publicly show trading leaderboards, spot, futures/ perpetual swap, options… where crypto-native firms actively market their competence, e.g. Gate.io Leaderboard

How do exchanges attract liquidity - Market maker Program
Exchanges uate market makers’ performance with the below criteria
● Spread: The closer a market maker’s quote (both bid and ask) is to mid-market, the better.
● Depth: The bigger the size of the quote (both bid and ask), the better.
● Uptime: The longer the qualified quoting time on both sides, the better.
● Trading scope: The more trading pairs covered in the ‘market maker Pair List’, the better.

Or simply consider maker trading volume, or maker volume participation rate of the exchange.

In return, exchanges incentivize market makers with better conditions in
● Connectivity: higher rate limit, low latency endpoints
● Commission: maker/taker fee
● Financing: zero/low-interest loan (or credit line)

Some exchanges even grant exchange equity or options to market makers.

Market Making Program uation Type
There are different ways that exchanges uate.
1.Simple: results-driven
2.As a maker, volume is a simple and direct way of measurement.
Exchanges uate market makers on maker volume, either by absolute value, percentage of the exchange, or ranking of all traders.
3.Medium - simple scorecard
4.Exchanges uate market makers with a scorecard, to incentivize certain behavior that is preferred by the exchanges, e.g., to make market for specific trading pairs with different weights (weight will be adjusted strategically from time to time), e.g., Gate.io Market Maker Incentive Program
5.Complex - scoring
6.Market makers will be incentivized according to a formula.
For example, the formula introduced by a DEX in 2021, was phenomenal at its launch, and was copied by several exchanges immediately.

Disclosure: This article is from 1Token, crypto-native technology provider since 2015.
1Token is a software provider for crypto-financial institutions, offering one-stop tech solution. For more information on 1Token, please visit https://1token.tech/