The Hermit Who Crosses Bull and Bear Cycles: Encryption Market Makers

The market-making business in the encryption market is not fundamentally different from traditional finance. However, there are significant differences in operational models, technology, risk management, and regulation. The scale of the encryption market is relatively small, with lower liquidity and greater volatility, requiring market makers to be more cautious in their risk management. The trading process in the encryption market is difficult to regulate, and there is no strict market maker system to impose constraints. The relationships between trading platforms, project parties, and market makers have become more complex. Market-making activities occur not only on centralized trading platforms but also involve on-chain market making, leading to the emergence of some middleware and protocols that serve market-making. In terms of technical architecture, the encryption industry needs to possess higher technical capabilities to ensure the security of transactions.

The market making business in the encryption market is a blue ocean, providing every investor with opportunities but also accompanied by risks. Currently, the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are tightening regulations on the encryption market, affecting many institutions and businesses. Coupled with the bear market conditions, the frequent occurrence of large institutional failures poses greater challenges for market makers' risk management. In addition, encryption market makers also face issues such as market fragmentation, low capital efficiency, regulatory uncertainty, and still-improving exchange technologies.

Even so, encryption market makers still have a large space for development and profitability. In the future, encryption market makers will also exhibit some development characteristics of traditional financial market makers.

1. Market makers are gradually diversifying.
2. Diversification of market-making varieties
3. High business leverage
4. The leading effect of market makers is becoming increasingly obvious.

In the investment field, you can focus on centralized small market maker strategies or service-oriented projects, tools that solve interoperability, and CeDeFi projects.

1. Traditional Market Maker Track

Market makers refer to institutions or individuals that provide liquidity in financial markets. Their main responsibility is to provide liquidity and market depth for the securities trading market. Market makers typically trade between buyers and sellers in the securities trading market and provide quotes in the market so that other traders can buy or sell based on those quotes. Market makers are usually composed of investment banks, securities companies, or professional institutions, and they play an important role in maintaining market stability and liquidity.

1.1 Industry Overview

Market makers perform six main functions in the financial markets:

1. Provide liquidity
2. Continuous Quotation
3. Manage Risks
4. Provide Consultation
5. Increase market efficiency
6. Provide innovative products

The clients of market makers mainly include traders, investment institutions, high-frequency trading firms, individual investors, and other financial institutions.

The development of the market maker track can be divided into five stages:

1. Before the 19th century: The initial stage of market makers, facilitating trades in traditional over-the-counter markets.
2. 19th century - 1970s: Standardized trading platforms emerged and developed rapidly, with market makers providing liquidity in the on-site market.
3. 1970s-1980s: Market makers began to gradually adopt electronic trading systems.
4. 1990s: Institutional investors and retail discount brokers rose, and the market share of dealer internal matching platform trading continued to increase.
5. 21st Century: The role of market makers has gradually expanded and consolidated, beginning to enter emerging markets.

According to FINRA data, as of September 2021, the number of registered legitimate market makers in the United States exceeded 500. Notable market maker companies include Jane Street, Citadel Securities, IMC Trading, Optiver, Susquehanna International Group, and Jump Trading.

1.2 Necessary Conditions for Market Maker Companies

To establish a market-making company, the following conditions must be met:

1. Understand the market
2. Establish a technology platform
3. Determine Capital Requirements
4. Implement risk management

1.3 Operating Model and Market Making System

Market makers provide liquidity through two-way quotes, and their operational model generally includes the following steps:

1. Select the underlying asset
2. Analyze the market
3. Provide Quote
4. Accept Transactions
5. Risk Control
6. Profit

There are two types of driving systems on the trading platform: quote-driven system and order-driven system.

1.4 Profit Model

The profit model of market makers mainly derives profits from the spread between buying and selling prices. In addition, profits can also be made through high-frequency trading, hedging, arbitrage, and other methods. The profit level of market makers usually depends on factors such as market volatility, liquidity, and trading volume.

1.5 Regulatory and compliance requirements

In the United States, market-making firms are required to strictly adhere to the regulatory requirements of the SEC and FINRA, as well as comply with securities laws. Additionally, market-making firms must also comply with requirements related to compliance and anti-money laundering.

1.6 Future Development Trends

The long-term challenges faced by market makers mainly include technical risks, legal risks, market risks, competitive risks, and operational risks. However, at the same time, with the continuous development of global financial markets, market makers also face more opportunities.

2. Encryption Market Makers

Market makers in the encryption industry are essentially no different from traditional finance; both provide liquidity to the market, quickly establish positions, and close them to gain the bid-ask spread. However, there are significant differences in operating models, technology, risk management, and regulation.

2.1 Development History

The development of market makers in the encryption market can be divided into three stages:

1. Initial (2009-2012 )
2. Development Period ( 2013-2017 )
3. Period of Great Change ( from 2018 to present )

2.2 encryption market maker's operating model

The operation model of crypto market makers is similar to that of traditional financial market makers, mainly providing liquidity and market depth for the cryptocurrency market while generating profits from it. The crypto market making process generally includes the following steps:

1. Filter currency pairs
2. Quotation
3. Matching Transactions
4. Risk Management
5. Settlement and Clearing

2.3 Market Making Technical Barriers

The technologies that encryption market makers need to master include:

1. Blockchain Technology
2. Security Technology
3. Digital Currency Trading Platform API
4. Data Analysis and Machine Learning
5. Social Media and Online Marketing

2.4 Trading Platform and Market Maker

There are two forms of cooperation between trading platforms and market makers:

1. Direct cooperation with encryption trading platforms
2. Collaborate indirectly with encryption trading platforms

2.5 Project Party and Market Maker

The relationship between the project party and the market maker is mainly established through the market maker providing liquidity services to the project party. The market maker serves three main functions:

1. Compensate for the shortcomings of insufficient market liquidity.
2. Stablecoin Price
3. Market Capitalization Management

2.6 The profit model of encryption market makers

The profit model of encryption market makers mainly includes:

1. Bid-Ask Spread
2. Collaborate with the project party to obtain benefits
3. Collaborate with trading platforms to earn rewards and rebates

2.7 Market Maker Evaluation Factors

Common indicators for evaluating market-making teams include trading volume and frequency, the precision and stability of quotes, profit margin and risk management capabilities, market share, and reputation.

3. Risk Analysis and Management of Encryption Market Makers

3.1 Regulation and Compliance

Encryption market makers are currently still in a regulatory gray area, but some countries and regions have begun to explore how to regulate encryption market makers.

3.2 Market Risk

Market makers face multiple risks in the encryption market, including price risk, liquidity risk, counterparty risk, and market-making capital risk.

3.3 On-chain and off-chain risks

The off-chain risks mainly involve transaction risks, while the on-chain risks include smart contract vulnerabilities, public chain forks, or slowed transaction speeds.

3.4 Risk Management

In order to control risks, market makers need to focus on trading quality, establish good cooperative relationships, maintain strict discipline, manage inventory risk effectively, and continuously monitor the market.

4. Encryption Market Maker Typical Case Analysis

4.1 FTX collapse and Alameda Research bankruptcy

After the FTX collapse, the bankruptcy of Alameda Research led to significant losses for FTX's market-making team, resulting in a lack of market liquidity.

4.2 Wintermute and DeFi hacking incident

In September 2022, Wintermute had its EOA wallet stolen, resulting in a loss of $160 million, due to the possible use of the Profanity tool to create attractive wallet addresses.

4.3 GSR Market

GSR Markets is an algorithmic digital trading company based in Hong Kong that provides liquidity for order execution solutions across several categories of digital assets using its own software.

5. Decentralized Market Makers

There are mainly three forms of decentralized market makers:

1. Participate in liquidity provision for DEX
2. Participate in the decentralized derivatives market
3. Participate in specialized services for market-making DeFi protocols

Encryption Market Maker Development and Challenges

The future development trends of encryption market makers are mainly reflected in the following aspects:

1. Strengthen risk management
2. Develop a more intelligent trading system
3. Strengthen liquidity
4. Explore new business models
5. Actively try on-chain protocol market making

The main challenges faced by encryption market makers include market fragmentation, low capital efficiency, regulatory uncertainty, and the exchange technology that is still being improved.

Investment Direction Consideration

In the market maker track, you can focus on the following investment directions:

1. Centralized market maker strategies or service projects
2. Projects that solve interoperability issues
3. CeDeFi Project

In general, cryptocurrency market makers need to continuously adjust their strategies and business models to adapt to market changes and demands. At the same time, they also need to strengthen cooperation and communication with other market participants to jointly promote the development and growth of the market.

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