Bitcoin has become a household name in recent years, as its value has soared and it has become more widely accepted as a form of payment. But how do market makers make money trading bitcoin? Market makers can make money by trading bitcoin in a few different ways.
They can charge fees for their services, earn interest on their inventory, or trade bitcoin for other assets, such as fiat currencies or other cryptocurrencies. Read more about how bitcoin exchanges work in our guide to how bitcoin works.
What Is A Market Maker?
Before founding Cove Markets, I worked for 14 years at IMC, one of the largest market makers in the world. An excellent 2-minute video on IMC’s website explains a market maker. In short, market makers are professionals who provide two-sided liquidity, i.e., orders to buy and sell. The difference is the bid-ask spread. They make money from this spread, not from forecasting where prices will go in the future. So, how to become a crypto market maker?
Who Are The Market Makers In Crypto?
The speed and convenience of trading stocks have continued to increase, particularly with app-based investment. Consumers may make trades using app-based platforms in seconds, depending on the kind of market order. However, market makers work behind the scenes to ensure this process runs well. The most prevalent market maker is a brokerage firm that provides investors with buy-and-sell services. These brokerages attempt to keep financial markets liquid while also making a profit.
How Do Market Makers Make Money Trading Bitcoin?
Concept of Theoretical Price
Market makers can make money in any asset class, whether stocks, bonds, options, or even cryptocurrencies. To do this, they need to calculate an unbiased theoretical price by considering several key inputs. These include short-term supply and demand, trading activity across multiple exchanges, and data from related instruments.
Then they need to place orders to buy and sell in the most efficient way possible, sometimes by placing limit orders around the theoretical price, other times by performing arbitrage by selling expensive products (or on expensive exchanges) and buying cheap products (or on cheap exchanges).
Decentralized Market Making
Automated market makers have grown in popularity on decentralized bitcoin exchanges in recent years (DEXs). Traditional order books are replaced on these platforms by liquidity pools made up of two separate cryptocurrencies. AMMs are used in DEXs to quote the price of two digital assets simultaneously.
Almost anybody may become a market maker by supplying liquidity to a chosen pool. These “liquidity providers” (LPs) receive a passive return on their deposits that is proportionate to the percentage of liquidity they supply to a pool.
Notably, each DEX protocol uniquely combines AMMs. Uniswap, for example, uses the Constant Product Market Maker (x * y = k), where x is the quantity of market move token in the liquidity pool and y is the amount of the other. In the formula, k denotes a fixed constant, implying that the overall liquidity of the pool remains constant.
Simple formulae like this are also used in protocols like Curve and Balancer. Others, like Bancor, utilize more sophisticated calculations to limit the temporary loss that market makers might experience due to price swings between the acquisition and sale of the sky crypto trading asset in the issue.
The CoveTrader platform calculates a theoretical price called the True Price. This is done across a variety of different cryptocurrencies, including Bitcoin (BTC-USD), Ethereum (ETH-USD), Litecoin (LTC-USD), and Bitcoin Cash (BCH-USD). We calculate a True Price per exchange and on the aggregate book.
True Price then allows us to track all trades in the market and compare the traded price to True Price. This difference, or “Diff” as we call it, can shed light on profitable trading moments where a trader was able to buy below True Price or sell above it. For example, suppose the True Price is 6374.82 when a trade occurs for 6380.05.
The Diff for that trade would be +5.23 (= Price – True Price). This difference multiplied by the traded size (e.g., Total (BTC)) equals the instantaneous profit on the trade. Every trade has a chance of the market moving for or against the position.
Therefore market makers try to make as many trades as possible and hope to lock in some of this difference, sometimes called “edge,” across their total trade activity.
You can read more about True Price and Diff here.
Crypto Market Making and Institutional Investing
Market creation has been an increasingly popular aspect of the bitcoin business. The increasing quality and quantity of conventional market makers in the crypto space providing liquidity through controlled exchanges (CEXs) has served as an essential indicator of the crypto industry’s maturity and has helped institutional investors’ growing engagement in crypto.
While reduced volatility and slippage, two of the primary benefits provided by market makers, are certainly beneficial to retail investors dealing in smaller order sizes, their significance is magnified for institutional investors such as hedge funds, investment banks, and family offices who may be trading millions, if not billions, of dollars.
As more institutional money joins the crypto sector, aided, among other things, by the development of more crypto option market making on CEXs, the business stands to evolve, even more, bringing up new opportunities in the crypto world.
Many traders of Bitcoin and other cryptocurrencies should invest more time and effort towards achieving good execution quality. While there might be long-term uncertainty in the price of these instruments, there are many clear examples of bad execution where traders give up free money to professionals. Cove Markets shares examples of these trades, like the one below, on our Twitter feed @CoveMarkets.
Automated Market Makers (AMM)
The first market makers, unlike now, did not have the luxury of mechanization. Shearson Lehman Brothers and ATD did not employ automated market makers until the early 1990s (AMMs). Previously, order books were the result of manually initiated transactions designed to increase market liquidity.
This manual method of market creation resulted in slippage and lag in price discovery, while the lack of transparency led to charges of market manipulation. AMMs addressed these issues by eliminating people from the market-making process, allowing for near-instant trading and more transparency.
Market Makers and Liquidity Services
Adequate liquidity benefits all stakeholders by making financial markets more efficient by lowering price volatility and promoting fair pricing. Order books – the collection of active buy and sell orders for a certain market — are critical to market liquidity.
The bid-ask spread is the difference between the highest bid price and the lowest sale price. Low liquidity markets often feature a broad bid-ask spread, generally indicative of low activity. On the other hand, more liquid markets often have a narrower bid-ask spread and more volume. By posting tighter spreads, market makers actively support liquid markets.
Market makers sometimes purchase and sell assets for their accounts and publish prices to an exchange platform to benefit from the bid-ask spread. The bid-ask spread is the difference between the asking and bid prices; the difference produces a profit for the market maker.
The charge pays market makers for the risk they take when they acquire and keep assets that lose value after they are purchased but before they are resold.
Market makers can make money trading bitcoin by taking advantage of the spread between the bid and ask prices. Market makers can profit from each trade by buying at the lower bid price and selling at the higher ask price. Thanks for reading!