From the perspective of Web3 project parties, viewing "both enemy and friend" crypto market makers

Author: Will Awang, Investment and Financing Lawyer

The myth of getting rich quickly in the crypto market exists every day. Most players come here not to double their money, but to turn their fortunes around. In this dark forest, crypto market makers, as the top predators closest to the money, appear increasingly mysterious.

Price manipulation, pump and dump, and harvesting the retail investors are synonymous with crypto market makers. However, before labeling crypto market makers with these "pejorative" tags, we need to recognize their important role in the crypto market, especially for early-stage token projects.

In this context, this article will explain what market makers are from the perspective of Web3 project parties, why we need market makers, the DWF incident, the main operating models of crypto market makers, as well as the risks and regulatory issues involved.

I hope this article will be helpful for project development, and I welcome discussions and exchanges.

1. What are Market Makers?

The globally leading hedge fund Citadel Securities defines market makers as playing a crucial role in maintaining continuous market liquidity. They achieve this by simultaneously providing buy and sell quotes, thereby creating a market environment with liquidity and market depth that allows investors to trade at any time, injecting confidence into the market.

Market makers are essential in traditional financial markets. On Nasdaq, each stock has an average of about 14 market makers, with a total of around 260 market makers in the market. Additionally, in markets with less liquidity than stocks, such as bonds, commodities, and foreign exchange markets, most trades are conducted through market makers.

Crypto market makers refer to institutions or individuals that help projects provide liquidity and buy/sell quotes on crypto exchange order books and decentralized trading pools. Their main responsibility is to provide liquidity and market depth for trading in one or more crypto markets and to profit from market fluctuations and supply-demand differences through algorithms and strategies.

Crypto market makers not only reduce trading costs and improve trading efficiency but also promote the development and promotion of new projects.

2. Why Do We Need Market Makers?

The primary goal of market making is to ensure that the market has sufficient liquidity, market depth, and stable prices, thereby injecting confidence into the market and facilitating transactions. This not only lowers the entry threshold for investors but also encourages them to trade in real-time, which in turn brings more liquidity, creating a virtuous cycle and fostering an environment where investors can trade with confidence.

Crypto market makers are particularly important for early-stage token projects (IEOs) because these projects need sufficient liquidity/volume/market depth to maintain market heat/popularity and to facilitate price discovery.

2.1 Providing Liquidity

Liquidity refers to the degree to which an asset can be quickly converted into cash without significant loss in value, describing how easily and quickly buyers and sellers can transact in the market at relatively low costs. A high liquidity market reduces the costs of any specific transaction and facilitates trades without causing significant price fluctuations.

Essentially, market makers promote faster, larger, and easier buying and selling of tokens for investors at any given time by providing high liquidity, without being interrupted or affected by significant price fluctuations.

For example, if an investor needs to immediately purchase 40 tokens, they can buy 40 tokens at a unit price of $100 in a high liquidity market (Order Book A). However, in a low liquidity market (Order Book B), they have two options: 1) Buy 10 tokens at $101.2, 5 tokens at $102.6, 10 tokens at $103.1, and 15 tokens at $105.2, with an average price of $103.35; or 2) Wait a long time for the tokens to reach the desired price.

Liquidity is crucial for early-stage token projects. Operations in low liquidity markets can affect investors' trading confidence and strategies, potentially leading to the "death" of the project.

2.2 Providing Market Depth and Stabilizing Prices

In the crypto market, most assets have low liquidity and lack market depth, meaning even small transactions can trigger significant price changes.

In the aforementioned scenario, after the investor purchases 40 tokens, the next available price in Order Book B is $105.2, indicating that a single transaction caused about a 5% price fluctuation. This is especially true during market volatility, where fewer participants can lead to significant price swings.

The substantial liquidity provided by market makers helps to form a narrower bid-ask spread, which is typically accompanied by solid market depth, aiding in stabilizing prices and alleviating price volatility.

Market depth refers to the available quantity of buy and sell orders at different price levels in the order book at a given time. Market depth can also measure an asset's ability to absorb large orders without significant price changes.

Market makers bridge this supply-demand gap by providing liquidity, thus playing a key role in the market. Imagine which market you would prefer to trade in:

The role of crypto market makers: 1) Provide substantial liquidity; 2) Provide market depth to stabilize prices, ultimately enhancing investor confidence in the project, as every investor hopes to trade their assets in real-time at the lowest transaction costs.

3. Who Are the Major Players in Crypto Market Making?

Market making can be considered one of the top-tier businesses in the food chain, as they control the lifeblood of project tokens after they go live. Market makers typically collaborate with exchanges, easily forming monopolies, with market liquidity dominated by a few large market makers.

(Crypto Market Makers [2024 Updated])

In July 2023, the crypto project Worldcoin, co-founded by OpenAI's Sam Altman, reached an agreement with market makers upon its official launch, lending a total of 100 million $WLD tokens to five market makers to provide liquidity, stipulating that the borrowed tokens must be returned within three months or purchased at prices ranging from $2 to $3.12.

These five market makers include:

A. Wintermute, a UK-registered company, with investment representatives including $WLD, $OP, $PYTH, $DYDX, $ENA, $CFG, etc., having invested in over 100 projects since 2020.

B. Amber Group, established in 2017, is a Hong Kong company with a board that includes familiar institutions like Distributed Capital. The team members are predominantly of Chinese descent. Projects involved include $ZKM, $MERL, $IO, etc.

C. Flow Traders, founded in 2004 in the Netherlands, focuses on providing global digital liquidity for exchange-traded products (ETPs) and is one of the largest ETF trading companies in the EU, creating exchange-traded notes based on Bitcoin and Ethereum and engaging in cryptocurrency ETN trading.

D. Auros Global, affected by FTX, applied for bankruptcy protection in the Virgin Islands in 2023, with $20 million in assets stranded on FTX, and news of a successful restructuring has emerged.

E. GSR Markets, established in 2013 in the UK, is a global crypto market maker specializing in providing liquidity, risk management strategies, programmatic execution, and structured products for mature global investors in the digital asset industry.

4. The DWF Incident

DWF Labs has recently become the most talked-about "celebrity" market maker in the market. DWF's Russian partner Andrei Grachev founded DWF in Singapore in 2022. It is reported that the company claims to have invested in a total of 470 projects and has collaborated with about 35% of the top 1000 tokens by market capitalization in its short 16-month history.

(Binance Pledged to Thwart Suspicious Trading—Until It Involved a Lamborghini-Loving High Roller)

Let's review this incident:

4.1 Whistleblower

On May 9, The Wall Street Journal reported that an anonymous source claiming to be a former Binance insider stated that Binance investigators discovered $300 million in false trading by DWF Labs during 2023. A person familiar with Binance's operations also indicated that Binance previously did not require market makers to sign any specific agreements to manage their trading (including prohibiting market manipulation or any specific agreements to regulate their trading behavior).

This means that, to a large extent, Binance allowed market makers to trade at their discretion.

4.2 DWF's Market Promotion

According to a proposal document sent to potential clients in 2022, DWF Labs did not adopt price-neutral rules but instead proposed using its active trading positions to drive up token prices and create so-called "artificial trading volume" on exchanges, including Binance, to attract other traders.

In a report prepared for a token project client that year, DWF Labs even stated that the agency successfully generated artificial trading volume equivalent to two-thirds of the token and was working to create a "Believable Trading Pattern." If collaborating with DWF Labs, it could bring "Bullish Sentiment" to the project token.

4.3 Binance's Response

A Binance spokesperson stated that all users on the platform must comply with general usage terms prohibiting market manipulation.

A week after submitting the DWF report, Binance fired the head of its monitoring team and laid off several investigators in the following months, with a Binance executive attributing this to cost-saving measures.

Binance co-founder He Yi stated that Binance has always conducted strict market monitoring of market makers; competition among market makers is fierce, and they may use PR attacks against each other.

4.4 Possible Reasons

On the Binance platform, DWF is at the highest "VIP 9" level, meaning DWF contributes at least $4 billion in trading volume to Binance each month. The relationship between market makers and exchanges is akin to a symbiotic one, and Binance has no reason to offend one of its largest clients for the sake of an internal investigator.

5. Main Operating Models of Crypto Market Makers

Like traditional market makers, crypto market makers also profit from the bid-ask spread. They set low buy prices and high sell prices to earn profits from the spread, which is typically referred to as the "Spread," and is the primary basis for market makers' profits.

After understanding this foundation, let's look at the two main business models of market makers for project parties.

5.1 Subscription Service + Performance Fee (Retainer + Performance Fee)

In this model, project parties provide tokens and corresponding stablecoins to market makers, who use these assets to provide liquidity for CEX order books and DEX pools. Project parties set KPIs for market makers based on their needs, such as acceptable price spreads and required market liquidity and depth.

A. Project parties may first provide market makers with a fixed Setup Fee as a startup cost for the project.

B. Subsequently, project parties need to pay market makers a fixed monthly/quarterly subscription service fee. The basic subscription service fee usually starts at $2,000/month, with higher fees depending on the scope of services, with no upper limit. For example, GSR Markets charges a $100,000 Setup Fee, a $20,000 monthly subscription fee, plus a $1 million loan in BTC and ETH.

C. Of course, some project parties may also pay KPI-based trading commission fees to incentivize market makers for profit maximization (incentives earned by market makers for successfully achieving KPI targets in the market).

These KPI indicators may include: trading volume (which may involve illegal wash trading), token prices, bid-ask spreads, market depth, etc.

In this model, the market-making approach is relatively clear and transparent, making it easier for project parties to manage, and is more suitable for mature project parties that have already built liquidity pools in various markets and have clear goals.

5.2 Token Loan + Call Option (Loan / Options Model)

The most widely adopted market-making model in the market is: Token Loan + Call Option. This model is particularly suitable for early-stage token projects.

Due to limited funds at the beginning of a token launch, project parties find it difficult to pay market-making fees, and with fewer circulating tokens in the market at the start, they lend early tokens to market makers, who also bear the corresponding risks.

In this case, it is more suitable for market makers to set KPIs based on the project's situation, and to compensate market makers, project parties typically embed a call option in the market-making contract to hedge against token price risks.

In this model, market makers borrow tokens from project parties (Token Loan) to inject into the market to ensure liquidity and stabilize prices, generally agreeing on a market-making period of 1 to 2 years.

The call option stipulates that before the contract expires, market makers can choose to purchase the previously borrowed tokens from project parties at a predetermined price (Strike Price). It is important to note that this option gives market makers a right to choose, not an obligation (OPTION not Obligation).

The value of this call option is directly related to the token price, providing market makers with the incentive to enhance token value. Let's simulate a scenario:

Assuming the Mfers project engages a market maker and signs a Call Option, agreeing to lend 100,000 tokens with a strike price of $1 for a term of 1 year. During this period, the market maker has two options: 1) Repay 100,000 Mfer tokens upon expiration; or 2) Pay $100,000 at the expiration (at the $1 strike price).

If the token price rises 100x to $100 (that's right, Mfers to the Moon), the market maker can choose to exercise the option, buying tokens worth $10,000,000 for $100,000, achieving a 100-fold return; if the token price drops 50% to $0.5, the market maker can choose not to exercise the option ($100,000) and instead directly purchase 100,000 tokens at $0.5 in the market to repay the loan (worth half the strike value, $50,000).

Due to the existence of the call option, market makers may have the motivation to pump prices and sell for profit; at the same time, they may also have the motivation to dump prices and buy back tokens at lower prices.

Therefore, in the Token Loan + Call Option (Loan / Options Model) model, project parties may need to view market makers as trading counterparts and pay special attention to:

A. How much the market maker obtains as the strike price and how many tokens are borrowed, as this determines the market maker's profit space and market-making expectations;

B. The duration of the call option (Loan Period), which determines the market-making space within this time dimension;

C. The termination clauses of the market-making contract, especially the risk control measures in case of emergencies. Particularly, after project parties lend tokens to market makers, they cannot control the tokens' whereabouts.

(Paperclip Partners, Founder’s Field Guide to Token Market Making)

5.3 Other Business Models

We can also see that many market makers have primary investment departments, which can better serve invested projects through investment and incubation, providing services such as fundraising, project promotion, and token listing, and having stakes in invested projects also helps market makers reach potential clients (investment-loan linkage?).

OTC (over-the-counter) trading works similarly, purchasing tokens at low prices from project parties/foundations and using a series of market-making operations to appreciate token value. There is more gray area here.

6. Risks and Regulation

After understanding the operating models of crypto market makers, we know that aside from the positive significance of market makers in the crypto market, they not only harvest retail investors but also target project parties as their "harvest." Therefore, project parties especially need to grasp the risks of collaborating with crypto market makers and the potential obstacles posed by regulation.

6.1 Regulation

In the past, regulation of market makers focused on "securities" market makers, and the current definition of crypto assets is still unclear, leading to a relative regulatory vacuum regarding crypto market makers and market-making behavior.

Thus, for crypto market makers, the current market environment is one where they can operate freely with low costs for wrongdoing, which is why we associate price manipulation, pump and dump, and harvesting retail investors with crypto market makers.

We see that regulation is continuously being standardized, such as the U.S. SEC clarifying the definitions of Broker & Dealer through regulatory enforcement, and the introduction of the EU MiCA legislation also brings market-making businesses under regulation. At the same time, compliant crypto market makers are actively applying for regulatory licenses, such as GSR Markets applying for a major payment institution license from the Monetary Authority of Singapore (allowing OTC and market-making services within Singapore's regulatory framework), and Flowdesk, which completed a $50 million financing at the beginning of the year, also received a regulatory license application in France.

However, the regulation of major jurisdictions does not prevent some crypto market makers from operating offshore, as they are essentially large capital accounts within various exchanges, and most do not have any onshore business.

Fortunately, due to the FTX incident and the ongoing regulation of major exchanges like Binance and Coinbase, crypto market makers symbiotic with exchanges will also be subject to the internal compliance rules of exchanges, making the industry more standardized.

We indeed need regulation to standardize these unethical/illegal behaviors, but before the industry erupts, we may need the industry to embrace the bubble.

6.2 Risks

Due to the lack of regulation, crypto market makers may have the motivation to engage in unethical trading and manipulate the market for maximum profit, rather than being motivated to create a healthy market or trading environment. This is also why they are notorious and can bring numerous risks.

A. Market Risks for Market Makers

Market makers also face market risks and liquidity risks, especially in extreme market conditions. The previous collapse of Terra Luna and the chain reaction caused by the collapse of FTX led to the complete failure of market makers, with leverage collapsing and market liquidity drying up, with Alameda Research being a typical example.

B. Lack of Control by Project Parties Over Borrowed Tokens

In the token loan model, project parties lack control over the borrowed tokens and do not know what market makers will do with the project tokens, which could be anything.

Therefore, when lending tokens, project parties need to view market makers as trading counterparts rather than partners and consider potential scenarios that may arise due to price impacts. Market makers can adjust prices to achieve various objectives, such as intentionally lowering prices to set a lower price for new contracts; they may also use anonymous voting to push favorable proposals, etc.

C. Unethical Behavior of Market Makers

Unethical market makers may manipulate token prices, exaggerate trading volumes through wash trading, and engage in pump and dump schemes.

Many crypto projects hire market makers to use strategies like wash trading to improve performance metrics. Wash trading refers to entities repeatedly trading the same asset back and forth to create the illusion of trading volume. In traditional markets, this is illegal market manipulation that misleads investors about the demand for specific assets.

Bitwise published a famous report in 2019 stating that 95% of trading volume on unregulated exchanges is fake. A recent study by the National Bureau of Economic Research (NBER) in December 2022 found that this figure has dropped to around 70%.

D. Project Parties Taking the Blame

Due to the lack of control by project parties over the borrowed tokens and the difficulty in restraining the unethical behavior of market makers, or the inability to know about these unethical behaviors, once these actions come under regulatory scrutiny, the project parties operating the projects will find it hard to escape blame. Therefore, project parties need to put effort into contract terms or emergency measures.

7. Conclusion

Through this article, project parties can clarify that crypto market makers contribute significantly by providing liquidity, ensuring efficient trade execution, enhancing investor confidence, facilitating smoother market operations, stabilizing prices, and reducing trading costs.

However, at the same time, by revealing the business models of crypto market makers, it alerts project parties to the numerous risks arising from collaboration with crypto market makers, which need to be particularly noted during negotiations on terms and cooperation execution with market makers.