Crypto Market Makers Explained

A market maker is a participant in a financial market who continuously quotes both buy and sell prices for an asset, creating a two-sided market that other traders can execute against at any time. In crypto, market makers are essential to the functioning of centralised exchanges and provide the liquidity that makes it possible for other traders to buy and sell without waiting for a counterpart who wants to take the exact opposite position at exactly the right moment.

Without market makers, exchanges would only allow trading when two parties with opposite intentions happen to submit matching orders simultaneously. This is impractical for most traders who want to execute at market prices quickly. Market makers solve this problem by maintaining a constant presence in the order book, quoting both sides of the market and earning a small profit on the spread between their buy and sell prices in exchange for taking on the risk of holding inventory.

 

How Traditional Market Making Works

A traditional market maker on a centralised exchange maintains a presence in the order book by continuously placing limit orders to buy below the current market price and to sell above the current market price. The difference between the buy price and the sell price is the spread, and it represents the market maker’s profit margin per unit traded. The market maker profits when traders buy at the ask price and sell at the bid price, collecting the spread on each round trip.

The risk for the market maker is inventory risk: if the price moves strongly in one direction, the market maker may accumulate a position on the wrong side of the move. If a market maker is buying BTC at $50,000 and the price falls sharply to $45,000, the market maker is holding a losing inventory position. Managing this directional risk through hedging, careful position sizing, and dynamic quote adjustment is the core challenge of market making.

Professional market makers use sophisticated algorithms that adjust their quotes continuously based on current inventory levels, recent volatility, order flow patterns, and broader market conditions. When their inventory on one side becomes unbalanced, they widen the spread on that side to discourage further imbalance and tighten it on the other side to encourage inventory reduction. This dynamic quoting allows them to manage risk while maintaining continuous market presence.

Market makers receive preferential treatment from exchanges in the form of reduced trading fees, often receiving fee rebates for adding liquidity to the order book. The maker-taker fee structure used by most centralised exchanges distinguishes between orders that add liquidity to the book, which are eligible for rebates, and orders that remove liquidity from the book, which pay a higher fee. Professional market makers exploit this structure to reduce their total fee burden.

 

Automated Market Makers in DeFi

Automated market makers, or AMMs, are the decentralised alternative to traditional order book market making. Instead of maintaining a quote in an order book, AMMs use a mathematical formula to automatically determine the price for any trade based on the ratio of assets in a liquidity pool. The most common formula is the constant product formula: x times y equals k, where x and y are the quantities of the two tokens in the pool and k is a constant.

When a trader buys token A from a pool, they add token B to the pool and remove token A. The constant product formula ensures that k remains constant, which means the price of A in terms of B increases as A becomes scarcer relative to B. This automatic price adjustment based on supply and demand within the pool is what constitutes the automated market making function. No human operator needs to manage quotes or inventory.

Liquidity providers, who are the equivalent of traditional market makers in an AMM, deposit equal value of both tokens in a pool to provide the liquidity that traders trade against. They earn a share of the trading fees generated by the pool proportional to their share of the total liquidity. However, they also bear the risk of impermanent loss, a form of opportunity cost that arises when the price ratio of the two tokens in the pool changes significantly from when the liquidity was deposited.

The AMM model democratises market making by allowing anyone to become a liquidity provider in a permissionless way. This is a significant departure from traditional finance where market making is dominated by well-capitalised professional firms with proprietary infrastructure. In DeFi, a retail investor can deposit liquidity into a pool and earn fees as a market maker, though doing so effectively requires understanding the risks and selecting pools with appropriate risk-reward profiles.

 

Market Makers and Exchange Liquidity

The quality of a crypto exchange’s market making directly affects the trading experience for all users of that exchange. Tight bid-ask spreads and deep order books, which reflect good market making, allow traders to execute large orders with minimal price impact and to get in and out of positions at prices close to the displayed market price. Poor market making results in wide spreads, thin order books, and significant slippage on any order of meaningful size.

New exchanges and new trading pairs on existing exchanges typically have poor initial liquidity because established market makers have not yet committed capital and infrastructure to those markets. Exchanges often pay market making firms directly to provide liquidity for new listings, particularly for smaller tokens that would otherwise have very thin markets. These arrangements are standard practice in the industry and help bootstrap liquidity for new assets.

For Australian crypto traders, the best Australian crypto exchanges maintain relationships with market makers to ensure competitive spreads and adequate depth for the assets they list. Understanding how market making affects the total cost of trading, including the spread as a hidden transaction cost in addition to explicit trading fees, helps you evaluate the true cost of using different exchanges and helps explain why prices on different exchanges may differ slightly at any given moment.

Flash crashes, where prices plunge briefly before rapidly recovering, often occur when market makers simultaneously withdraw their quotes from the order book, typically due to technical issues, risk limits being hit, or extreme volatility that makes quoting too risky. The resulting absence of market maker liquidity means even small sell orders drive prices dramatically lower until new buyers or returning market makers fill the gap. Understanding this mechanism helps explain why flash crashes happen and why the crypto market is vulnerable to them.

Market makers are the invisible infrastructure that makes liquid, efficient crypto markets possible. Whether through traditional order book market making on centralised exchanges or through automated market makers in DeFi, they play an essential role in creating the liquidity that enables all other market participants to trade. Understanding their role and incentives makes you a more sophisticated market participant. The Shepley Capital membership provides deeper analysis of market structure and trading. Stay current through the Capital Nexus newsletter.

 

How Market Makers Generate Revenue in Crypto

Market makers profit from the bid-ask spread: the small difference between the price at which they are willing to buy an asset and the price at which they are willing to sell it. By simultaneously posting both a buy order and a sell order for the same asset, a market maker captures the spread on every completed round-trip transaction. While individual spread margins are small, the volume of transactions a market maker processes allows these margins to accumulate into substantial revenue.

In cryptocurrency markets, spreads on major assets like Bitcoin and Ether on large exchanges can be fractions of a cent, reflecting the intense competition among market makers. On less liquid altcoins and on smaller exchanges, spreads can be considerably wider, offering higher per-trade margins in exchange for higher inventory risk. Market makers managing positions in less liquid assets must carefully manage the risk that their inventory changes in value before they can offload it.

Inventory risk is the primary challenge for crypto market makers. Unlike traditional financial assets, cryptocurrencies can move 5% to 15% within a single trading day. A market maker holding a large inventory of a particular token that suddenly drops in value faces immediate losses that can exceed the accumulated spread revenue. Managing this risk requires sophisticated hedging strategies, position limits, and rapid inventory adjustment mechanisms.

 

Automated Market Makers vs Traditional Market Makers

The emergence of decentralised exchanges introduced an alternative model of market making based on algorithmic liquidity pools rather than professional firms. Automated market makers, commonly known as AMMs, use a mathematical formula to determine token prices based on the ratio of assets held in a liquidity pool. Anyone can contribute liquidity to an AMM pool and earn a share of the trading fees generated by that pool, effectively becoming a passive market maker.

The most widely used AMM formula keeps the product of the two pool assets constant. If a pool holds equal values of Token A and Token B, buying Token A with Token B changes the ratio, automatically adjusting the price of both tokens. As more of Token A is purchased, the price rises; as less remains in the pool, each additional unit becomes more expensive, creating a natural pricing curve without requiring a centralised order book.

Traditional market makers operating on centralised exchanges work with order books, where buy and sell orders are matched based on price and time priority. These firms use algorithms that process real-time market data and adjust their quotes dynamically in response to order flow, volatility changes, and risk parameters. The key advantage of traditional market makers over AMMs is their ability to incorporate more market information into their pricing, which generally results in tighter spreads and lower transaction costs for large trades.

 

Market Making and Exchange Liquidity Incentives

Cryptocurrency exchanges actively compete for market maker participation because deep order books and tight spreads attract more traders, which in turn generates more fee revenue for the exchange. To secure the participation of professional market making firms, exchanges offer significant incentives, including reduced or zero trading fees, rebate programmes that pay market makers a portion of the fees generated by trades they facilitate, and in some cases, direct payments in exchange tokens.

The maker-taker fee model, used by most centralised cryptocurrency exchanges, directly reflects this dynamic. Traders who add liquidity by placing orders that do not execute immediately, known as makers, pay lower fees or receive rebates. Traders who take liquidity by placing orders that match existing orders immediately, known as takers, pay higher fees. This structure creates a financial incentive for market makers to provide liquidity continuously.

Market quality varies significantly across cryptocurrency trading venues based on the participation of quality market makers. Exchanges that attract well-capitalised, sophisticated market making firms typically exhibit tighter spreads, deeper order books, and better price discovery. Exchanges that rely primarily on retail traders to provide liquidity tend to have wider spreads, thinner order books, and greater price impact for larger orders. When evaluating where to execute significant crypto trades, considering the market depth and liquidity quality of an exchange is as important as looking at the headline fee rate.

 

How Market Depth Affects Your Crypto Trades

Market depth, also known as the order book depth, refers to the volume of buy and sell orders available at various price levels at any given moment. A deep market has many orders stacked at prices close to the current price, meaning that even large buy or sell orders cause minimal price movement. A shallow market has sparse order book depth, meaning that relatively small trades can shift the price significantly.

For everyday retail traders executing modest transaction sizes, market depth is rarely a concern on major pairs like Bitcoin-AUD or Ether-USDT on reputable exchanges. However, traders executing large orders or trading less popular altcoins quickly discover the practical impact of shallow markets. Understanding that market makers are responsible for providing much of this depth helps explain why their presence and the incentives designed to attract them are so central to the health of any crypto trading venue.

 

Further Learning

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