DODO Research: An in-depth analysis of market-making strategies in the crypto industry.

Original Title: "Dispelling the Myth of Market Makers"

Source: DODO Research

FTX suffered a major blow, causing a series of top platforms to collapse. Market makers and lenders were hit hard: Alameda, one of the largest market makers in the cryptocurrency industry, was destroyed in this farce and officially ended trading on November 10th; Genesis, a market maker and lending company under DCG, also faced a crisis of insufficient solvency.

The collapse of top market makers, the destruction of a large amount of capital, and the sharp one-sided market trend... all of these have caused unprecedented panic among industry market makers. In the aftermath, market makers tend to stop trading, and the community and projects face huge stress tests, causing a significant decrease in market liquidity in the cryptocurrency industry.

Whether in traditional or cryptocurrency markets, when it comes to market makers, it always feels like playing a game of blind man's bluff for the general public investors.

Now let's start from scratch and demystify market makers.   

Market Makers in the Cryptocurrency Industry

What are market makers, how do they make markets, and how do they profit?

According to Wikipedia, a market maker is a financial intermediary that buys and sells securities or other financial instruments in order to facilitate the trading of those instruments. In the United States, market makers are referred to as "specialists" on the New York Stock Exchange, while in Hong Kong they are known as "dealers" and in Taiwan they are called "liquidity providers".

As the name suggests, a market maker is someone who creates the "market".

In the traditional financial market, a market maker is a commercial organization, usually a brokerage firm, large bank, or other institution, whose main job is to create liquidity in the market by buying and selling securities.

Market making is an established and mature financial practice in which market makers provide liquidity and depth to the market. Buyers and sellers do not need to wait for a trading counterparty to appear, as long as a market maker is willing to take on the counterparty risk, the transaction can be completed. Market makers profit from the bid-ask spread, which is the difference between the buying and selling prices in the market. This spread is the main source of profit for market makers. They can also increase trading volume and profits by receiving rebates from trading platforms. The bid-ask spread is also known as the 点差 (Bid-Ask Spread) in Chinese.

In a liquid market with many buyers, sellers, and market makers, the spread is small and market makers need to conduct a large number of trades to make a profit. They use highly advanced quantitative algorithms to establish very short-term positions - from a few hours to a few seconds. The greater the market volatility, the more trades market makers can make and the more profit they can earn.

Buying this asset requires 103, selling this asset yields 97, and the market maker earns a spread of 6.  

In short, market making is providing bilateral quotes to any given market, providing market size for both buyers and sellers. Without market makers, the market will relatively lack liquidity, which will hinder the convenience of trading.

Market Makers in the Cryptocurrency Industry

Whether in traditional or crypto markets, liquidity is the lifeblood of all trading markets, and market makers are the helmsmen at the helm. In the crypto market, market makers are also known as liquidity providers (LPs), which may directly point out that, like traditional markets, the crypto market needs market makers to help guide the "invisible hand" of the market to solve liquidity traps.

This liquidity trap is mainly manifested in a vicious cycle: cryptocurrency projects need people (cryptocurrency exchanges and cryptocurrency investors) to contribute to token liquidity; at the same time, these people will only participate when the token has market liquidity. And this is where Market Maker comes in.

In simple terms, market makers use liquidity to nurture liquidity. A project typically needs the support of market makers to provide liquidity, confidence, and upward price pressure for their token market until the trading volume is sufficient for them to maintain the trading ecosystem on their own.

  How professional cryptocurrency market makers solve market liquidity problems for projects   

What is the use of market makers?

Take cryptocurrency as an example. The most crucial point, of course, is liquidity, which is the foundation of any efficient market.

Powerful pricing function: Market makers can track price changes over the long term, make judgments on fair market prices, and provide the most referenceable quotes. For example, platforms like 1inch not only guide funds to different liquidity pools, but also invite market makers (such as Wintermute) to provide quotes. 

Enhance market liquidity: Investors can trade directly with market makers without waiting or searching for counterparties. Market making is providing bid and ask quotes to any given market, which is the core of providing liquidity.  

Improve overall market efficiency: Market makers provide quotes through various trading platforms and help eliminate market chaos through arbitrage, which helps improve overall market efficiency. For example, Kairon Labs currently connects to APIs from more than 120 exchanges, providing assistance in reducing the impact of price fluctuations. 

Beneficial for new token promotion and reducing issuance costs: Market makers will drive trading volume to continuously increase, as well as a large number of new tokens appearing in multiple cryptocurrency exchanges. 

Increased trading volume and market expectations: Attracting investor attention, enhancing market confidence, and thereby driving up token prices. Facilitating large-scale transactions: Market makers are themselves suitable counterparties for institutional investors to conduct large-scale transactions. 

Market Making Strategy

Market-making strategy refers to a strategy that involves setting limit buy and sell orders, using the fluctuation of the underlying asset price to trigger limit orders, and obtaining trading profits through the price difference between buy and sell orders. This belongs to the risk-neutral spread arbitrage strategy in high-frequency trading strategies. Simply put, it is the middleman making a profit from the price difference, as mentioned earlier.

Twitter user 0xUnicorn analyzed common market maker trading strategies in a tweet, categorizing them as spot and futures. The specific strategies include delta-neutral market making (i.e. self-hedging inventory risk), high-frequency "real-time" market making, and grid market making. For more information, please refer to the tweet.

In essence, the focus of market-making strategies is on the number of limit orders and the setting of buy and sell order quotes relative to the mid-price. Therefore, in various classic market-making strategies, the main research is on the estimation of the mid-price, and then buy and sell orders are placed at appropriate positions on both sides of the mid-price. Therefore, market makers are most afraid of sharp one-sided market trends, because this means that buy and sell orders will have one-sided transactions, and a large amount of risk positions will accumulate in their hands.

Risk, Opportunity, and the Wild West

As mentioned above, the main risk comes from inventory risk.

When accumulating a large amount of inventory, it also means that the possibility of market makers not being able to find buyers for their inventory is greater, leading to a risk of holding more assets at the wrong time (usually during depreciation). Another situation is that market makers have to sell inventory at a loss to maintain operations when asset prices rise.

In DeFi, handling market-making risks may require more caution. For example, perpetual contracts. Market makers often use the funding rate of perpetual contracts (the core of this mechanism is to anchor the contract price to the spot price) to arbitrage between spot and leverage. In short, they create positions of equal value and opposite direction in the spot/leverage and perpetual contract markets. Therefore, market makers may face significant liquidation risks under abnormal price fluctuations because they may hold large positions due to arbitrage with different funding rates.

Opportunities come from high returns behind high risks. Even a 0.01 USD spread can generate a profit of 10,000 USD when such trading orders are executed one million times a day. Market makers also provide leverage to traders, and once a client's position is liquidated, the market maker can settle the trader's margin. According to Coinglass data, the daily amount of cryptocurrency liquidation ranges from 100 million to 1 billion USD. This will enable market makers to gain huge profits.

Undeniably, the encryption market is still in its early stages, and compared to the very mature market-making operations in traditional financial markets, there is still a crazy side running here. If we zoom in on some of the details of encrypted transactions: relatively low asset liquidity; significant slippage risk; and the possibility of a flash crash when large orders appear or when a large number of sell orders cancel the best bid in the order book. These characteristics often bring some hidden corners or profits to encryption market makers.

Overall, due to technical and regulatory factors, the sense of chaos and uncertainty still prevails among market makers, the cryptocurrency market, and users.

Arrived in the wild west. When a market maker promises a specific trading volume level to a token issuer, the next step will be a more ambitious promise: the token price will rise to a specific level. How to achieve this?

Wash Trading: Novice players will place a large sell order and then place a buy order for themselves within a few seconds. A more advanced player will use smaller orders and place them for a longer period of time; at the same time, to avoid detection by the exchange, they will operate from multiple accounts instead of just one account.  

Pump-and-dump: Among all the price manipulation strategies, the practice of pump-and-dump is particularly common. Social networks are the best pioneers. Once there is enough FOMO sentiment, selling a large number of tokens purchased in advance can be profitable. 

Ramping: Ramping refers to creating an impression of a big buyer. Market makers can use this strategy to create a "big buyer" who will make large trades during a fixed time period. FOMO emotions come into play here, and other traders will rush to get ahead of the "big buyer" (but ultimately become losers) - when the market notices this behavior, prices naturally rise. Of course, once the market maker's activity ends, the ghost buyer will mysteriously disappear, and the token price is likely to experience a sharp drop.

Cornering: When a token has multiple market makers, one market maker can try to make money by attempting to buy up most of the available tokens, forcing other market makers to raise their prices because they must maintain the same level of spread.

Due to a complete lack of regulation, these speculative operations do indeed appear in the execution strategies of market makers, ultimately disrupting the market, eroding confidence in trading assets, losing the trust of the exchange, affecting the reputation of the project party, and leading to long-term losses.

Yes or No: Everyone is a Market Maker  

Market Makers and Automated Market Makers

Although market makers (MM) and automated market makers (AMM) sound similar, they are completely different entities.

As mentioned earlier, in traditional finance, a market maker is an institution or platform that proposes various securities trading to multiple exchanges, providing liquidity to the market and profiting from the difference in buying and selling prices.

AMM is a decentralized exchange (DEX) protocol, unlike traditional exchanges that use order books, assets are priced based on specific pricing algorithms, and the pricing formula varies with different protocols. For example, Uniswap uses the following mathematical curve to determine the trading price: x * y = k. Where x and y are the quantities of the two assets in the liquidity pool, y is the quantity of the other asset, and k is a fixed constant, meaning that the total liquidity of the pool must remain unchanged.

The working principle of AMM is similar to that of traditional order book trading platforms, both of which set trading pairs (such as ETH/DAI). However, the former does not need to trade with specific counterparties. In the AMM mechanism, traders interact with smart contracts to "create" their own markets. The liquidity in the smart contract is provided by liquidity providers (LPs). As a reward for providing liquidity to the protocol, liquidity providers earn fees from trades conducted in the trading pool.

AMM: Everyone is a market maker

In traditional finance terminology, AMM refers to a method of simulating human market-making behavior through algorithms. In the DeFi space, it has gradually evolved into a powerful engine.

It uses automated algorithms to balance the supply and demand of tokens in the trading pool, avoiding the situation where one token cannot be traded due to a one-sided market (no buyers/sellers on the market) that may occur in the order book mode. Unlike other market makers, such as CEX market makers who profit from the bid-ask spread by adjusting their positions to control inventory based on their own strategies, DEX market makers provide liquidity in a different way and also earn transaction fees. When this part of the transaction fee is given to liquidity providers, it will encourage them to inject idle assets into the trading pool to provide liquidity, which to some extent solves the problem of insufficient trading depth in the order book mode.

Based on AMM, DEX has been proven to be one of the most influential DeFi innovations. The emergence of AMM has broken the limitations of order books and matching, helping DEX break the monopoly of CEX on the cryptocurrency trading market and making open and free on-chain transactions a reality. It is also AMM that allows ordinary users to participate in market making in a permissionless manner, allowing every DEX to proudly proclaim: Everyone is a market maker.

No need for permission, efficient and transparent, self-created market, everyone can enjoy the benefits of liquidity creation. The market-making vision described by DEX sounds too perfect.

LP Why is it losing money?

Now let's take a clear look at the vision and reality.   

The first question, will users become LP and profit from providing liquidity on DEX? (One voice: Have you forgotten about impermanent loss?)

In a widely cited study on Uniswap v3 LP losses, rekt cruelly pointed out that users are better off HODLing than providing liquidity on Uniswap v3. The study can be found at https://rekt.news/uniswap-v3-lp-rekt/.

As stated in the article, during the period from May 5th to September 20th when V3 was launched, 17 asset pools with TVL > $10 million (accounting for 43% of TVL) and trading volume exceeding $100 billion earned LPs about $200 million in fees. However, during the same period, IL caused losses of over $260 million, resulting in a net loss of over $60 million. In other words, around 50% of V3's LPs were in the red.

Although Uni V3 popularized the concept of leveraged liquidity provision - where the trading range providing liquidity is narrowed and higher capital efficiency is achieved by eliminating unused collateral - this leverage increases the fees earned but also increases the risk taken, as high leverage liquidity will face higher impermanent losses.

The reason for returning to Uni V3's design goal: customized market making. For users, higher proactivity means that market making operations become more complex. LP income depends on the LP's ability to judge the market, increasing the LP's decision-making costs and leading to uneven LP income. This design also gave rise to the phenomenon of JIT (Just In Time) attacks (using V3's centralized liquidity, setting the same block to add and withdraw LP positions, which can strictly define the range of positions to match transactions and dig out the amplified part of transaction fees).

Improving capital efficiency while sacrificing returns - this is not what LPs want to see.

This leads to the next question: Will users who provide liquidity on DEX always lose money as LPs?

Let's answer this question simply: Whether a DEX market maker is profitable or not depends not only on their subjective ability, but also on the model of the pool that provides the trading.

Traditional AMM model pools - there is no difference in profit logic between ordinary users providing liquidity and professional market makers, and market makers' funds and external quotes are limited by the AMM function. Essentially, it is a competition of TVL, which determines who can receive higher transaction fees.  

Customizable price pools - such as Uni V3, Balancer V2, Curve V2, and DODO V2 - allow market makers to actively intervene in the pool's pricing. Market makers can use these tools to profit from the price differences and lags between CEX and DEX markets (and with many DEX aggregators now available, better pricing means a greater chance of the pool being captured by an aggregator).

One of the reasons for LP's loss is choosing a solution that is not suitable for themselves.

Why does the head DEX provide pools with customizable prices? It's not just Uni V3. When liquidity is evenly distributed on the curve, there is a problem of high slippage and dispersed liquidity. Therefore, traditional AMMs want to improve capital efficiency. Uni V3, Balancer V2, Curve V2, and DODO V2 mentioned earlier are all moving towards centralized liquidity optimization.

By comparison, the advantage of active market making is that users can concentrate liquidity in a certain range by adjusting prices, which improves capital efficiency, resulting in lower slippage and deeper depth of trading. However, the disadvantage lies here as well. It increases the threshold for ordinary users to participate in market making to some extent, and is more suitable for professional market makers. Although the profit may increase, we must admit that the risk of losing money also increases. After all, ordinary users cannot compete with professional market makers in terms of professional skills and market sensitivity.

Everyone is a market maker, and we need to re-understand this slogan: everyone can become a market maker, but not everyone can be a good market maker.

Head market maker collapse: market loses liquidity afterwards

Market Makers in Dominoes

FTX Empire collapsed, a series of top platforms suffered heavy losses, and market makers and lending became hard-hit areas: Alameda, one of the largest market makers in the cryptocurrency industry, collapsed in this farce and officially ended trading on November 10th; Genesis, a market maker and lending company under DCG, suspended redemptions and new loan issuance in its lending department due to FTX's explosion and insufficient solvency, while seeking an emergency loan of $1 billion from investors.

As a crucial part of the domino effect in the cryptocurrency industry, what impact does a market maker bring?

Market liquidity has significantly decreased.

FTX Leverage Incident - Market Maker Collapse - Liquidity Gap. With the disappearance of top market makers, it can be expected that market liquidity will decrease significantly. Other market makers will also suffer more losses due to the collapse of FTX, which will further widen the gap. A cruel reality that corresponds to this is that cryptocurrency liquidity is dominated by only a few trading companies, including Wintermute, Amber Group, B2C2, Genesis, Cumberland, and Alameda. It has only been half a year since the March credit crisis, and when the market is shrouded in shadows again, market making will become more difficult.

According to Kaiko's data tracking, since CoinDesk published its investigation into Alameda's asset situation, BTC liquidity within 2% of the mid-price has dropped from 11.8k BTC to 7k, the lowest level since early June. This article also presents many data points indicating that the market's overall liquidity has been significantly impacted by the collapse of Alameda and other market makers suffering losses.

Fortunately, there has been a slight recovery in the past week, indicating that market makers are redeploying capital. However, it is obvious that this process is very slow.

 The total amount of BTC within 2% of the median price has increased from 6.8k to 9.1k. In terms of USD, the market depth has increased from 112 million USD to 150 million USD.  

 Token Liquidity and Project Pressure Testing

Alameda has invested in dozens of projects, holding low-liquidity tokens worth millions of dollars (as Alameda is also a market maker, they are also the main liquidity provider for these tokens). Although it is not yet clear the full details of Alameda's and FTX's token holdings, according to the Financial Times' breakdown of FTX's balance sheet, "this is a systemically important market maker". Especially for tokens other than BTC and ETH, the extreme market conditions brought about by a collapse undoubtedly pose a huge stress test for these projects.

For example, SOL (Solana) is one of the heavily invested tokens by Alameda Research. According to CoinDesk's report, Alameda held approximately $1.2 billion worth of SOL tokens on June 30th. SOL is one of the best-performing tokens in the 2021 bull market, but it has now dropped 95% from its historical high.

This kind of collapse: the tightening of liquidity brought about by the Belt and Road Initiative and the risk brought to the DeFi ecosystem through large-scale liquidation may also lead to bad debts for lending protocols; secondly, it may lead to a collapse of confidence, a large amount of pledged tokens flowing out, increasing the possibility of interruption, bringing stability and security risks, and reducing the cost of network-level attacks.

In the weeks following the implosion of FTX and Alameda, SOL plummeted from around $35 to around $11, a drop of 68.5%.  

Double Collapse of Confidence and Trust

More importantly, it is the dual collapse of confidence and trust.

Confidence: The "Black Swan" event has shaken the industry's confidence in so-called high-performance public chains, and to some extent, has also undermined users' and supporters' confidence in FTX's series of ecological projects. **Confidence is worth more than gold, and fear is more terrifying than hell.** The cryptocurrency market has experienced two Lehman moments in the past six months, the Luna/Terra incident and the Three Arrows Capital incident, which have taught users what uncertainty is and brought a panic that spreads faster than a virus to the cryptocurrency market.

Trust: In the collapse of Alameda in the cryptocurrency industry, we can see how the top-tier market makers in the industry, for example, had their entire trading business mixed with customer funds by FTX in an improper manner. However, for investors and project parties, they had no way of knowing. Of course, this is the trust that CeFi has been invisibly demanding from the public since the beginning, but when the market's once good reputation, numerous endorsements, and large scale market makers also show their naked ugliness, you still feel disillusioned with the trust in the world of cryptocurrency. Although we have said many times: FTX/Alameda Blockchain.

When the market loses liquidity

As mentioned earlier, liquidity is the driving force behind any market.

When the overall market trend is downward, the withdrawal of top market makers undoubtedly adds insult to injury, which means that more projects and investments tend to slow down, and thus a vicious cycle will emerge here (until the fundamentals recover):

The market slows down - liquidity falls, or a major crisis appears - sharp one-sided market - market-making activities decrease - trading volume and investment activities decrease - liquidity falls - market slows down.

  SRM and MAPS have also experienced a significant decline in depth, and market-making activities have been affected by Alameda.  

In order to maintain liquidity in the cryptocurrency market, many market makers provide liquidity to blockchain exchanges and financial protocols. Therefore, when there is a decrease in market making or market making activities, there may be a decrease in trading volume and investment. Here we need to distinguish: liquidity will normally decrease when it fluctuates, because market makers extract sell/buy price tasks from the order book to manage risk and avoid adverse liquidity; however, in the event of a major crisis or market maker withdrawal, market liquidity will face severe challenges for a period of time.

You can see that currently, the liquidity is more severely affected than any previous market downturn, and the market's recovery in the bear market is extremely slow. This indicates that the liquidity gap this time may persist in the short term.

So what should we do?

DODO How to meet market-making needs?

As mentioned earlier, we actually mainly raised two questions:

1. When AMMs are all optimizing towards concentrated liquidity, and when becoming an LP to provide liquidity may become a challenging or even unprofitable task, how can market makers still generate profits? 

2. How to rebuild trust and truly utilize the decentralized nature of the crypto world to bring much-needed liquidity to project parties and provide market makers with true permissionless and efficient transparency when the FTX scandal causes the collapse of top market makers and market liquidity?

Regarding the second question, the answer was already self-evident when it was proposed: Use DEX, Use Blockchain. Let's go back to the chain, back to the code, back to "don't trust, verify".

Regarding the first question, there are already many protocols or platforms in the market that provide corresponding liquidity management tools to help LPs manage risks and stabilize returns. Here, perhaps a solution from DODO can be provided: bringing professional market makers onto the chain.

In the article "Interview with DODO Market Maker: How to Improve Market Making Efficiency with DODO", market maker Shadow Labs mentioned that after deducting various fees such as gas fees, net profits of 30-40% of on-chain public revenue can be obtained. For example, in the market maker pool of WETH and USDC on DODO, the market maker's year-to-date net profit reached $500,000 after deducting various fees, with a net profit rate of approximately 36.2%.

How to achieve that?

As we all know, AMM is usually referred to as "passive liquidity" because the price points provided to traders cannot be controlled, unlike traditional market makers who are more knowledgeable and flexible. This is where DODO comes in and creates the PMM (Proactive Market Making) algorithm. The PMM algorithm adjusts the pricing curve using price predictions, with simple yet flexible parameters. The flatter curve effectively increases capital utilization, reduces trading slippage and impermanent loss. For more information on the efficiency improvement of different algorithms on concentrated liquidity, please refer to "In-depth comparison of Uni V3, CurveV2, DODO market-making algorithms - efficiency improvement brought by concentrated liquidity".

Aside from these familiar topics, we want to talk about DODO's V2 version that was launched in March of this year. The DODO Private Pools (DPP), also known as private pools, are pools specifically designed for professional market makers to provide liquidity.

Private pool, as the name suggests, can be independently provided by market makers with their own funds for market making, and the market making process can flexibly modify the private pool configuration, including transaction fee rate, current external reference price i, curve slippage coefficient K, and also support adjusting the fund size of the pool. All these modifications are implemented by relevant accounts triggering smart contracts (including two methods, calling DODO DPPProxy contract and directly calling the underlying private pool for market making modification, specific operation steps can refer to: DODO V2 Private Pool Operation Instructions). Therefore, this pool mainly meets the market making needs of professional market makers.

Regarding yield performance, according to DODO's data statistics, the total yield of the WETH-USDC liquidity provider on Polygon is 16%, and the total yield of the liquidity provider pool on BSC (launched at the end of July) has reached 10% or even 22% in the past four months, which is relatively impressive.

Currently, there is no DPP pool on Ethereum, and most market makers choose to build pools on Polygon and BSC chains with lower gas fees.  

Additionally, the article In-depth comparison of Uni V3, CurveV2, and DODO market-making algorithms uses liquidity distribution data to analyze the efficiency improvement brought by concentrated liquidity. By selecting the WETH/USDC market maker pool as a sample, the article shows the mean liquidity ratio between price ranges of 2%, 6%, and 10%. DODO V2's market maker pool has a liquidity ratio of 83.1% within the 2% range.

Let professional market makers enter the chain, because decentralized exchanges are naturally trustless, non-custodial, and permissionless, which is the direction of future trading and market making. However, due to cost and efficiency issues, solutions based on the AMM framework have made slow progress in this area. DODO's PMM algorithm and DPP private pool provide professional market maker teams with highly flexible market making curves, reducing market making costs, improving capital efficiency, and bringing efficient market making experience. In a market environment with declining liquidity, it also provides project parties with a better choice for cooperation.

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