What is market making?
Market making is a trading strategy that lets traders make money when executed with relatively stable instruments. Market makers earn their profits by providing liquidity for other traders. They do so by creating limit orders in both directions and they take the bid-ask spread as their earned income. Let me explain with a picture.
The idea behind the strategy is simple: buy low, sell high. If, let's say, BTC is trading at $17,000 a pop, you create a buy order for $16,999 and a sell order for $17,001. When both orders get filled you earn $2, the spread, for providing liquidity to other traders.
Let's calculate relative profitability of the market making strategy. Relative profitability means we'll calculate it in percent, relative to the capital that you're using in this strategy.
Suppose you want to be a market maker and you allocate $10,000 to this strategy. Let's also suppose that you're trading EOS/ETH on EtherDelta. As of writing this article, 1 EOS is trading for roughly $8, and EtherDelta has $0.26 bid-ask spread.
As you remember, one market maker's trade consists of creating two orders, buy and sell, and then waiting for them to fill. So, you create a buy order for $8 and a sell order for $8.26. When they both get filled you earn $0.26.
The formula for calculating relative profitability on each trade is spread / (2 * price). In our case, that's 1.625% on each trade. Not bad, considering that you can keep doing the same thing over and over again and easily get to 100 trades a day. Let's see what happens when you do so and reinvest the profits from each trade.
Profitability on GDAX BTC/USD
For ease of calculations let's pin BTC price to $17,700. GDAX is a fairly established exchange and, due to its centralized nature, it's able to execute deals so fast that it consistently has the minimal $0.01 spread. Let's see what a market maker can earn if they invest $10,000 into this strategy.
To put things in perspective, 100 trades with $10,000 fund is one million dollars in volume. For providing this much liquidity to the market you're only rewarded with about 2.5 cents. This leads me to believe that GDAX either has some behind the scenes agreements with market makers and the exchange provides them with rebates, or that GDAX does market making themselves.
In short, market making BTC/USD on GDAX is hardly worth it.
Profitability on EtherDelta EOS/USD
Decentralized exchanges, such as EtherDelta and Saturn Network, typically have larger spreads, which is perfect for market making. For this and the next examples we'll simulate earnings with a number of different spreads: 1 cent, 6 cents, 11 cents, 16 cents, 21 cents and 26 cents.
Again, for ease of calculations, we'll pin EOS price to $8.
Now, these are much better numbers! If the spread is 1 cent you'll end up earning $644.74, or roughly 6.4%. However, if we take the current spread of 26 cents, you'll end up with $50,125.17 on a $10,000 investment!
Profitability on EtherDelta ZRX/USD
Let's see how the picture changes when we market make an asset with another price, such as ZRX. Since the value of ZRX is currently $0.35 we will not experiment with out-of-this world spreads, and we'll take the 1 cent spread that EtherDelta currently has as the baseline.
Wow. Even with 1 cent spread the returns are mind blowing. You can easily do a 100 trades a week and get 400% returns if you do market making right!
When can market making go wrong?
Market making is profitable when the underlying instrument has a relatively stable exchange rate. There are two cases when market making breaks down. Again, let's use the same BTC/USD example.
BTC goes to the moon
When BTC suddenly starts moving upwards, your buy order, the one that tries to buy low, doesn't get filled. However, your sell order will sell just fine, but at the price that you set in advance, so you'll miss the ride to the moon.
In this case you'll simply fix your position in USD. You'll miss the gains you could have had by simply holding BTC, but you'll keep your money in dollar equivalent.
BTC goes to $0
If BTC suddenly goes bust, as it did in 2013 when Mt. Gox exchange collapsed, then your sell order will never get executed because everybody is trying to sell to someone else.
In this case, if your bot keeps running, you'll end up buying all the BTC that's available on the exchange with your dollars. Sounds pretty good in theory, but not when BTC has zero dollar market cap.
- Market making is a fairly simple trading algorithm. It allows traders to earn money by exploiting market's inefficiencies (big bid-ask spread). It also fixes this inefficiency: market making reduces the bid-ask spread making it easier for regular traders to buy and sell; it provides liquidity for those traders too.
- Market making has its risks. If the price of the instrument you trade changes in any direction in a significant way in a short period of time you will always end up on the losing side.
- The more efficient the exchange is, the less profitable market making becomes. However, an exchange depends on market makers providing liquidity. In this case most exchanges simply start market making themselves just to keep the exchange alive. Due to this reason Saturn Network runs a decentralized loyalty program where paid trading fees are reimbursed with SATURN tokens. The protocol itself ensures that trading volume will increase because market takers have an incentive to continue trading, making it a better and more efficient exchange for everyone.