Market makers and liquidity providers offer essentially the same service — which is, you guessed it, liquidity. Liquidity itself is a multi-faceted concept but is nonetheless essential to the strength of a financial market.
Liquidity boils down to volume on an exchange. If there is enough volume to fill orders quickly and at an asset’s intrinsic market price, then that venue has high liquidity. Generally, this equals a flourishing market with a healthy amount of buyers and sellers available to purchase or sell assets, whenever.
Exchanges without a lot of liquidity (also called illiquid markets) make it difficult to purchase or sell an asset at its inherent market price. An illiquid market can also put buyers and sellers in an uncomfortable position — forcing them to keep an entry until there is enough liquidity to complete the transaction at a reasonable price. In the volatile world of cryptocurrency, holding a position for an extended period can seriously destroy your portfolio.
Think of it this way: you’re a trader, and you’d like to buy or sell an asset, but the exchange you’re operating on can’t find enough orders to complete the transaction. You’d still be able to buy the asset, but it won’t be for what the asset’s market value is. You’d probably leave this exchange for another, right?
Here is where a market maker, or liquidity provider, would come in. It’s his or her job to ensure that liquidity is offered as a last resort when there aren’t enough orders to fill yours.
Another problem caused by low liquidity is the increased effect a single transaction can have on a financial market, eating up an order book quickly and incurring a higher than average price. This is opposed to a market with high liquidity, which can withstand many transactions at once and still have plenty of the order book to spare on new ones.
This need for liquidity is the same for every market, and a lack of liquidity can impose a dangerous problem for exchanges and their users. There are a few different ways to provide liquidity, the traditional market maker route, or in the case of DEXs — whose liquidity is inherently lacking — liquidity mining.
John Todaro, director of research at TradeBlock, a provider of institutional trading tools for digital currencies, says this of DEXs and their lack of liquidity:
“Given institutions typically operate within a specific regulatory sandbox, they are more comfortable trading through centralized exchanges than DEXs. Further, the majority of retail flows are concentrated on centralized exchanges. Using a DEX requires a deeper understanding of wallets and exchange order books than using a centralized exchange such as Coinbase which can be accessed via a smartphone app, and thus has limited the customer pool for DEXs.”
Both established exchanges and new exchanges use a “market maker” of some kind — even the New York Stock Exchange (NYSE) uses in-house liquidity providers to act as market makers. If big exchanges like NYSE need these parties to keep their market liquid, imagine crypto venues, who already have a not-so-easy path to success!
Luckily, as DeFi grows in popularity, new solutions are being conceived to address this problem, approaching it through decentralized means.
But first, what is a liquidity provider? For that matter, what is a market provider? On the surface, not too much. They both provide the same service, but the way they approach the problem is innately different. We’ll delve into what they are and how they differ from each other.
What is a Market Maker?
Market makers are high volume traders that, you guessed it, provide liquidity for multiple trading venues at a time. They are the more traditional choice when opting for a liquidity provider and can include third-party and cross-exchange entities.
With third-party market makers, the “party” is usually a hedge fund. They act as arbitrageurs, sourcing liquidity from other exchanges by hedging their positions in other markets. Market makers strike a deal with the venue they operate on, usually asking for a certain profit level for providing liquidity. If the maker’s profits fall below the agreed-upon rate, the exchange will generally pay the difference as per the agreement.
Some market makers source their profit from the bid-ask spread, the discrepancy between an asset’s best bid (the maximum price a buyer is willing to pay for an asset) and best ask (the best, or lowest, asking price for the selling of an asset). In other words, buying the token low and selling it high. Increasing the spread increases the amount of money a market maker will generate for a given transaction but will shrink exchange volume. Thus, the amount of time that passes between transactions increases, raising his or her level of risk. Why? Well, it gives other market makers time to capitalize on the position (potentially before the original market maker can). Time is also an issue due to the ever-fluctuating price of an asset.
What Are Liquidity Providers?
While market makers and liquidity providers perform the same task, liquidity providers equip the crypto space with something quite unique. While market makers have ties to the traditional financial sphere, the concept of liquidity providers was birthed in classic crypto fashion: a new way to provide liquidity to a market without a third-party.
LPs utilize liquidity pools rather than the traditional peer-to-peer order book. The order book system operates on the bid-ask spread mentioned above. In contrast, liquidity pools involve deposited asset pairs like ETH/USDT, ETH/USDC, ETH/DAI, and ETH/WBTC. These asset pools provide a new market for each pair of tokens. Anyone can create a liquidity pool, and anyone can contribute liquidity to any pool, so long as they’ve staked the asset pairs in question. The person who creates the pool and stakes a particular asset pair also sets the initial price of those asset pairs. They, and each liquidity provider after, are incentivized to provide the pool with an equal value of both tokens. LPs receive LP tokens based on the amount of liquidity they’ve provided, and LP token holders are rewarded via the fees traders pay to utilize the exchange (these fees can be high).
Because there are no order books, an asset’s price is kept constant in relation to its global price through a smart contract that executes a mathematical formula. Price variations depend on both the size of the trade and liquidity pool for a given asset.
It may be a little complicated, but luckily most DEXs have streamlined this process in an easy-to-use UX design. Providing liquidity in a traditional financial market ordinarily requires more time, effort, and money overall.
It’s not just about decentralization, although having a decentralized option is undoubtedly necessary for DEXs. It’s also about efficiency, safety, and cost-effectiveness. Liquidity providers seem to allow for all four. But, it’ll be a while before we’re able to see this mechanism on a larger scale.
Certainly, the approach — and the execution — are why projects like UniSwap, AAVE, Maker, and Curve are so high up on the DeFi totem pole. It’s also why DeFi as a whole has become so popular, with $11B locked at the time of writing. Who knows, maybe DeFi and DEXs will disrupt the traditional finance space, but one thing is sure. We’ll need to see several more scalable examples of this decentralized alternative to market-making in the years to come.
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