The market making mechanism has permeated the universe on many different levels. It’s so subtle we may not be aware of it. However, it has been constantly making undetectable impacts in our daily decision-making processes, adjusting the parameters of the lens that we use to view the world, and more importantly making things happen.
Market making in everyday life
The expression “market maker” consists of two words “market” and “maker”, yet “maker” is indeed the one that deserves more weight for its interpretation. Let’s imagine a world without “makers” and as such, nobody stands on the other side of our decisions. We would have to hunt for our food because the food market or supermarket do not exist.
If we travel to a foreign country, we wouldn’t be able to exchange foreign currencies with such unnoticeable fees at banks. You will need to find a person with the foreign currency you want and try to exchange with him or her. Chances are you may have to pay a relatively high cost because both of you do not know the “fair” exchange rate. It’s hard not to be grateful that we are living in such a world that “makers” are making things happen for us, yet we often under-appreciate their services.
What market makers bring to the table
Market makers are also traders. Balancing between transaction cost and opportunity cost is the core of the market making business. Market makers place “limit orders” to take on a financial position, which means there are chances that the position may not be taken. Thus, they often play around their profit margin (spread) to optimize their chances.
It’s like a supermarket in your neighborhood trying to attract you to purchase their paper towels by giving you an extra 30% discount at the end of the month. As soon as the limit orders are executed, they own the risk of carrying that position, just like any trader does.
Market makers have different views about the market among themselves. Sometimes their views contradict each other bringing the market into a state of so-called equilibrium. In fact, without their existence, the market could become vulnerable to manipulation by those who have the most amount of resources. Eventually, this could provide a stepping stone for the rich to get richer, creating a long tail for our Pareto wealth distribution or bending the 80/20 rule into a 95/5 one.
The risks in market making
Market makers make predictions as all traders do and like any trader, they could be wrong about the prediction which leads them into loss. In extreme cases, those losses could be tremendous and cost them the entire business when an incorrect prediction is coupled with system failures. This is when their mathematicians and engineers need to review their work.
Moreover, no market maker is able to carry an unlimited amount of inventory of an asset without beating their heart out, just like you can’t find an unlimited amount of paper towels in supermarkets’ warehouses. When market makers take on a position, they carry an inventory risk of not getting rid of the position while keeping the little profit they have just made. With all these chips on their shoulders, market makers’ jobs are unimaginably challenging. These risk takers deserve some credit and attention by serving as agents to uphold stability for the market, providing an endless stream of valuation on the asset that matters to us, and making things happen for us.
AAX welcomes market makers
AAX partnered with LSEG technology to bring the latest matching engine technology, offering ultra-low latency which accommodates exceptionally high throughput. This feature (amongst many others) attracts market makers, and the abundance of market makers pledges stable supply of cryptocurrencies at competitive prices and helps facilitate true price discovery.
On the flip-side, we also monitor market makers to ensure that both the exchange and specific market maker is made aware when the relevant market making obligation is not being met.
To find out more about AAX or to pre-register please visit www.aax.com.