The Past of the Dealer: The Love and Hate Between Market Makers, Project Parties, and Exchanges
Users are not just users; they are also buyers.Written by: Guangwu, Founder of Canoe
Source: Shenchao TechFlow
The former head of trade at FTX, @octopuuus, mentioned an interesting perspective from the market maker's institutional viewpoint in a podcast, "The Past of Market Makers lol."
I will first summarize the aggressive market-making style of Alamenda that he mentioned, and then add some other models I know from the previous cycle, especially the relationship between project parties and market makers. The market makers referred to in this article specifically refer to the part of the business associated with exchanges and project tokens.
Institutional Trading Perspective
From an institutional perspective, there are two main ways to control a token's chips:
Strong Market Control
In the case where the project's fundamentals are sound, choose a target to start operations (the project party may know or may not know, which is not very important).
Phase One - Accumulation: The typical market behavior is to continuously accumulate at low prices.
Phase Two - Consensus Phase of Market Maker Institutions. The main indicator in this phase is trading volume, first raising a wave, then exchanging hands with other market makers during fluctuations (recovering costs, improving capital utilization, establishing risk control models).
Phase Three - Harvesting Phase. Further raising the price while offloading to recover funds, and at the same time, pushing the price up. In this step, some institutions may also voluntarily assist the project party in building the fundamentals.
Creating Value Anchors for Targets
This involves rapidly improving the quality of the project's fundamentals in terms of funds and trading volume.
The best means are lending and derivatives.
An example shared by @octopuuus is lending, such as borrowing BTC/ETH by collateralizing FTT, making the value anchor of FTT BTC and ETH. Through cyclical lending and leverage, it may even be possible to use the borrowed BTC/ETH to buy FTT.
Another method is relatively professional futures (which can be used as margin, non-perpetual contracts) and options, which is relatively complex. In a bull market, market makers in the crypto space may not even need to use this weapon to complete market making.
Relationship Between Project Parties and Market Makers
From the perspective of project parties, the relationship between projects and market makers can be roughly categorized as follows (from top-tier to ordinary studios):
If the project party actively seeks listing, exchanges will have requirements for market makers:
Some exchanges may even designate certain market makers. During the listing phase, market makers can help a lot, which is why many project parties in the previous cycle liked to take investments from MM.
Market-making accounts have margin requirements, such as token + USDT not less than $150,000, which can generally be bargained.
Terms from Large Market Makers:
One type is passive market makers (more common in Europe), who provide strategy and technical support, managing hundreds of project parties, with monthly fees possibly ranging from $3,000 to $5,000.
Another type is a technical service fee (about $6,000/quarter) + profit sharing (more common in China). Profit sharing refers to the profit from selling tokens. For example, if $1 million worth of goods is sold, the split might be 70/30. This type of market maker has a certain interest binding with the project party, but the market maker holds the initiative. A key indicator in negotiating terms is the reserve ratio: market-making reserve funds / circulating market value. If one wants to have control over the market, this ratio generally needs to be around 30% to 50% to prevent the risk of a crash (falling below the private placement price).
Another type is a common practice among American market makers. Borrowing terms, for example, borrowing 3% of tokens from the project party, and repaying the principal and interest at an agreed price upon maturity. Such terms are illegal in the U.S., so the terms are generally explained to clarify the differences and responsibilities concerning U.S. securities. The initiative still lies with the market maker, who can choose to return tokens or USDT. The project party has relatively little say.
Returning tokens is relatively easy to understand; whatever is borrowed is returned. If returning USDT, there is a difference: some top market makers will return USDT at the price of their investment round (possibly slightly inflated). If the exchange price is far above the private placement round, the market maker's profit can be substantial. Some market makers are relatively friendly, returning USDT to the project party at the average price on Binance on the agreed day, where the average price is generally defined as the daily volume weighted average price.
The superpower of the previous cycle: private placement investment + borrowing a large amount of tokens from the project party at the private placement price. Based on the above analysis, if the market maker chooses to return USDT, the potential profit can be maximized; for example, if the private placement price rises 100 times and is sold, that is a 100-fold profit. In a sense, this is a low-cost (even zero-cost) purchase of an American call option; the higher it goes, the greater the option's value. In American finance, this corresponds to liquidity Service Level Agreements (SLAs), which strictly prohibit such terms.
Small market makers are relatively simple (there are also project parties and incubators with their own market-making teams, often referred to as the big scissors in the crypto space): primarily charge fees, doing whatever the project party says. They generally provide daily asset updates and offer some suggestions and ideas. Unlike large market makers, they have relatively good communication with project parties, as they manage too many projects and primarily engage in passive market making.
The optimal choice for project parties is to be strongly listed by exchanges and have their market controlled by market makers. Project parties only need to focus on building, quietly offloading, and making a fortune. During high trading volumes, achieving $100 million in trading volume on Binance during a bull market is not difficult; a project party can offload $1 million daily without affecting the market. This explains why project parties in the mid-bull market do not care about the quality of VCs and just want to get listed as soon as possible. For example, during the recent GameFi wave in Vietnam, VCs directly recouped their investments during the TGE phase, even making several times their investment, with very high capital turnover efficiency. They could even recoup funds within a month and then slowly invest in good projects during the bear market. However, this can easily lead to collapse.
Supplementing the downsides of being controlled. Project parties may incur losses if they uniformly manage the VCs' chips, sell them all at low prices, and then get controlled by market makers to pump the price. In that case, project parties may have to pay back the VCs whose chips were managed. Moreover, some may focus solely on building; if the token rises 100 times without selling, and then the product has issues and goes to zero, it results in a one-round game. Many such cases exist; the market makers profit while the project parties bear the blame. If the price is pumped up 50 times, retail investors who buy at that price will blame the project parties for a year, when in fact it was primarily the market makers (wild market makers) doing it, leaving the project parties with no recourse. Generally, project parties with good fundamentals are rule-abiding, with transparent chips, and do not act recklessly. If they do, no funds will be willing to engage with their tokens.
Of course, market makers are not evil; they are simply in the business of funds. What I have introduced is mainly about proactive market makers. If a market maker does not have primary investment operations, they simply adjust strategies based on market conditions, with little action. If the market is a riverbed, then market makers are at one end supplying water. It is normal for project parties to have weak bargaining power in front of market makers; in the secondary financial market, the food chain's water source is these market makers. But ultimately, they also have their own sources of water, with losses and gains, and even bankruptcies.
Relationship Between Market Makers and Exchanges
Having mentioned exchanges earlier, let’s add some insights into the shadow banking system formed by market makers and exchanges:
Currently, during the bear market when liquidity is depleted, top exchanges frequently contact market makers, begging them to provide liquidity. Because liquidity is the most fundamental infrastructure for exchanges.
Back to the bull market. Why do exchanges with such large profits need to misuse customer assets to expand their balance sheets? A significant portion of the exchange's balance sheet is allocated to market makers as unsecured loan credit lines, and market makers use this capital to continuously thicken liquidity, some even leveraging it, bringing ample liquidity. This effectively grants market makers the right to misuse customer assets. When we were amazed by the enormous liquidity in 2021, thinking these institutions were the saviors of the secondary market, we realized during the actual blow-up that the liquidity providers were precisely us retail investors.
Exchanges generally provide market makers with many favorable conditions: no fees, unsecured loans, low interest rates. Why were market makers and hedge funds (like 3AC) willing to pay over 10% interest for loans in 21/2 years? Because some of these rates are covered by exchanges, not paid by market makers. Some exchanges frequently provide market makers with unsecured loans to replace liquidity management costs.
ps, this part is relatively complex, so I will list a table to describe the debts, losses, and profits between market makers and exchange operations.
- FTX & Alamenda took this system to the extreme; when exchanges directly recharge market makers for liquidity (misusing customer assets), the fallout can be enormous, affecting every user. After FTX's collapse, market liquidity plummeted by over 50%.
- In summary, exchanges rely on market makers for liquidity, while market makers print money on one side (unsecured loans) and leverage bets on the other, leading to many financial blow-ups and shadow banking debt crises, with the loans coming directly from customer principal.
Future: The Relationship Between Market Makers and AMM
Of course, these are some scripts from the previous cycle; no one knows how the next cycle will play out. For example, many new ventures in 22 have set up hedge fund departments to escape the profit squeeze from the market maker system.
Regarding the relationship between projects and market makers, there were also some interesting developments in the previous cycle. One project I prefer is Merit Circle, which directly raised $105 million through LBP financing and then opened LP mining on UNIV2/3, achieving liquidity in the top ten, second only to ETH/USDC, with considerable depth. Moreover, they raised enough money through LBP, making the listing irrelevant, but with such large trading volumes, they were still strongly listed by Binance. Currently, the publicly disclosed treasury assets of this gaming guild still amount to $100 million during the deep bear market, with the address under public supervision and updated in real-time daily.
LBP was initially used for fair launches, but later, during favorable market conditions, it became an excellent tool for project monetization and exit: it can be profitable without market maker involvement, breaking free from the exchange-market maker profit system. Additionally, the liquidity pool after LBP ends can also serve as an exit for VCs.
Aggressive market makers have experienced a round of blow-ups and purges; the next cycle's internal market-making operations within exchanges should undergo significant changes. It will be interesting to explore what means can decentralize related operations and segment permissions and assets on-chain. In the previous cycle, centralized market-making became increasingly familiar with the DEX system, and some mainstream aggregated DEXs have introduced RFQ functions specifically to serve professional market makers. Recently, Binance has listed Hashflow, which also focuses on RFQ. However, traditional market makers still face high barriers to entry in the DEX field, often requiring 2-3 months to familiarize themselves before daring to use funds for MM market making. Additionally, on-chain delays and performance issues can render many strategies ineffective. I anticipate that in the next cycle, based on high-performance chain trading engines and engineering implementations without Solidity/Vyper language restrictions, there will be further promotion of professional market makers establishing liquidity in the DEX space, shifting pricing power from CEX to DEX.
Another consideration is the issue of market makers using AMM for market making. AMM represents a passive convex curve for market makers, a passive convex function curve, and with impermanent loss, it is challenging to pump and control the market. After v3 was released, it became slightly more user-friendly, but it requires frequent price range adjustments, making market making difficult to manage. Izumi has discretized the v3 function for management, but even after discretization, within that defined domain, it remains a passive convex curve, so managing liquidity based on discretization does not achieve proactive market making and control.
One of my main research directions in the future relates to this, such as whether it is possible to construct a new function form to achieve a transition from passive to positive. First, I will build a mathematical definition of passivity around t, and a possible direction of thought is to transform and eliminate t, similar to how Fourier transforms convert time-domain functions into frequency-domain functions. If proactive management and leverage operations for market makers can be achieved in DeFi, the risks associated with the original shadow banking system can be significantly mitigated.
Postscript
The above is what I know about market makers, and the small operational advice I can offer is to choose those targets that are open and transparent, as well as those that have been screened and evaluated on major platforms, which can be used as collateral and margin.
Originally, while organizing this information, I was merely inspired by @octopuuus, but as I wrote, I couldn't help but think of those people I have seen online and around me. They may be weak youths bearing the burdens of their families, husbands and fathers wanting to slightly improve the lives of their wives and children; they may be cautious programmers who occasionally work overtime, or workers with small dreams; they may be sons who have told one lie after another to their families, ordinary people who no longer have the chance to regret and start over. They pour their dreams, lives, and families into this rule-less market game, which may ultimately lead to disillusionment.
For market makers, it is a business; For retail investors, it is their entire life;
In fact, for project parties that chose to bind with market makers from the beginning, isn't it the same? "Users are not just users; they are also buyers." But in the end, it will still backfire.
