How to provide liquidity to cryptocurrency exchange

Published at: Sept. 7, 2020

A trading venue’s liquidity represents how easily a trader can use the platform to exchange one asset for another. If a trader sends a market order to buy or sell an asset and the venue can’t find enough buy or sell orders to complete the transaction at a reasonable price, the venue is likely struggling with low liquidity — and the trader is likely to take their future business elsewhere.

Venues that provide adequate liquidity and competitive market pricing tend to experience a rewarding cycle, with traders who find their liquidity needs met, returning for more transactions, which provides liquidity to other traders acting as counterparties. Liquidity can also help lessen the effects of individual transactions on an asset’s marketplace conditions. A venue struggling with low liquidity for a given asset will see a large portion of its order book eaten up by a single transaction. This means that the order will crawl higher up the order book and incur a higher average price (or a lower one for traders trying to sell).

The orders left standing are less likely to accurately represent the asset’s price averaged across many venues. A venue with high liquidity, however, can withstand a flurry of quick transactions before consuming a large portion of its order book, leading to better fills and happier customers.

Liquidity is essential for success, both in crypto exchanges and in far older and traditional financial markets. That’s why institutional venues such as the New York Stock Exchange often partner with in-house liquidity providers. Those providers act as market makers, playing a major role in defining an asset’s short term market value by readily providing liquidity when the buy/sell orders that traders send to them are executed.

Liquidity can be a little harder to come by for venue builders in the much younger world of crypto — but that doesn’t mean venue operators are out of options. As crypto finance becomes more and more sophisticated, venue operators are finding ways to provide traders with the liquidity they crave. Three promising options are third-party market makers, cross-exchange market making and liquidity mining. Different liquidity solutions can tie up different amounts of capital and operational capacity, so there is no one-size-fits-all strategy.

Third-party market makers

Crypto market maker agreements essentially replicate the in-house liquidity solutions that are popular in institutional finance venues. A venue makes the agreement with an outside liquidity provider — most commonly a hedge fund. These providers usually trade in many different venues at once and can source the liquidity they need for one venue by executing trades at other venues.

Unlike market takers, who are willing to pay more than they’d prefer to obtain an asset because they value holding the asset itself, market makers are willing to buy or sell any asset as long as they can capture a marginal profit by hedging their trade on another venue and maintain their desired inventory levels. To stabilize a long-term partnership, market makers and trading venues will often agree on a certain profit level that makers can expect to generate each month. If the maker’s profit falls below that amount, the venue agrees to pay the difference.

Venues may add extra incentives in the agreement. For example, some makers will agree to provide loss leader pricing, which quotes the lowest price found across multiple exchanges in order to attract traders from other venues. Trading platforms also sometimes offer makers increased margin levels. Venues regularly review their market makers’ balance sheets to ensure the maker’s creditworthiness. This review process helps venues decide which accounts will be allowed to temporarily trade to negative account balances.

Approved market makers can settle their obligations daily and, under some circumstances, weekly, which may mean that the trading venues’ short term liabilities will temporarily exceed the assets under their management until settlement occurs. Market makers with increased margin levels can lend out inventory and/or arbitrage for other opportunities within settlement windows to increase their returns.

Market makers or exchanges that enter a formal liquidity environment may also have specific requirements when it comes to technical integration between the venue and the liquidity provider. Makers who represent a financial institution often prefer to interact with exchanges via Financial Information Exchange, or FIX API, a standardized communication protocol for financial data. This protocol is fast, efficient and optimal for co-located servers. Some less institutional traders may prefer to use a WebSocket protocol, which is mostly targeted at retail investors. This method is still viable for high-frequency trading but is often slower than FIX and can handle fewer requests per minute due to rate limit restrictions.

Cross-exchange market making

In this strategy, traders can still turn to a market maker — but the maker is the venue operator rather than a third party. Thanks to cross-exchange transactions, the venue can source liquidity without risking significant losses.

Venue operators serve as market makers at their own venues — the “maker exchange” — and simultaneously act as market takers at one or more other venues — the “taker exchange.” Those external taker exchanges — also known as source exchanges — have their own liquidity providers, who set bid and offer prices for other market participants to take. Operators on the maker exchange use those bid and offer prices to set market-making conditions at their own venue, oftentimes with a markup to the source exchange.

In the example above, the venue operator will buy an asset sold on the maker exchange for $98, the lowest price available, while simultaneously selling that asset on the taker exchange for $99. Their inventory levels remain the same, and they not only haven’t lost capital but have actually made a small profit of $1. Likewise, the operator can sell an asset for the best offer they encounter on the maker exchange — $101 — while simultaneously recovering that inventory without losing any capital by repurchasing it on the taker exchange for $100. The exchange operator can continue this process repeatedly to generate revenue.

Cross-exchange market making lets venue operators source liquidity without paying a third party to do it for them, but this strategy comes with capital efficiency issues. The market maker service providers we discussed in the prior section often have lines of credit at multiple venues, letting them trade on margin rather than collateralizing the full amount of asset inventory they post for each trade. A venue operator practicing cross-exchange market making without access to credit has to keep significant inventory in their taker exchanges, making it difficult to use that capital for any other profit-generating purpose or for frequently necessary rebalancing across trading venues.

Liquidity mining

Market making was an important service in traditional financial venues before crypto even existed, and cross-exchange market making between different crypto venues is a logical extension of this traditional finance concept. Liquidity mining, however, is a strategy with much closer ties to crypto itself as an asset class.

Cryptocurrency has gained (and continues to gain) traction because of its uniquely decentralized structure. That decentralization is deeply tied to community participation. Many blockchain protocols, for example, reward individual participants for staking coins or running nodes. When structured properly, these rewards incentivize the distribution of computing power across a wide network of independent participants, which, in turn, makes the protocol itself more decentralized and thus more resilient.

Liquidity mining extends the blockchain tradition of turning to the community for decentralized support of important crypto functions. Venues that turn to liquidity mining eschew any singular market-making source whether it’s a partnership with a professional market-making firm or their own cross-exchange market-making algorithm. Instead, they distribute open-source software to any participant who wants to download it.

These newly enlisted liquidity miners connect their crypto wallets and set parameters for the software to automatically execute market-making trades on participating exchanges. A pool of rewards is algorithmically generated and distributed among miners, with miners who tolerate more risk receiving greater rewards.

Final thoughts

There is no one-size-fits-all liquidity solution, and every strategy features drawbacks and inefficiencies. Liquidity mining is a theoretically promising strategy that’s now being implemented on-the-ground in a handful of crypto venues, but it still has a long way to go before it’s proven scalable for mainstream trading.

Cross-exchange market making not only creates capital inefficiencies but can also drive traders away due to the venue’s conflicted interests: Though venue operators execute the strategy to provide liquidity, they do so by trading against and sometimes profiting off of exchange clients. Market-making agreements have put off some crypto enthusiasts who prefer a decentralized approach and a definitive movement away from the world of traditional finance, but for many exchange operators, these agreements are realistically by far the most effective liquidity solution, providing access to credit lines and highly liquid non-crypto venues.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, readers should conduct their own research when making a decision.

The views, thoughts and opinions expressed here are the authors’ alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

This article was co-authored by Warren Lorenz and Aly Madhavji.

Warren Lorenz is the chief strategy officer of Pipefold — a non-custodial clearinghouse for digital assets that eliminates counterparty risk, liquidity risk and hacking risk, helping institutions to efficiently allocate capital across crypto markets. Warren is also a limited partner at Weave Markets — a digital asset hedge fund — and was the previous managing director of trading operations at Amplify Exchange. As an entrepreneur, Warren has built multiple products that were licensed and sold to hedge funds, proprietary trading offices and family offices.

Aly Madhavji is the managing partner at Blockchain Founders Fund, which invests in and builds top-tier venture startups. He is a limited partner at Loyal VC. Aly consults organizations on emerging technologies, such as INSEAD and the United Nations, on solutions to help alleviate poverty. He is a senior blockchain fellow at INSEAD and was recognized as a “Blockchain 100” Global Leaders of 2019 by Lattice80. Aly has served on various advisory boards, including the University of Toronto’s Governing Council.