While the collapse of cryptocurrency exchange FTX and its Alameda Research subsidiary is believed to have left many crypto players, including market makers, in the worst possible position, according to Andrei Grachev, managing partner at DWF Labs, the incident may have helped “kick out companies that weren’t Sustainable enough to operate during a storm.” As a result, “the market will be healthier” in the future.
The art of market making
Besides excluding vulnerable players, Andrei Grachev suggested in a written response to questions from Bitcoin.com News that the collapse of major players in the crypto industry such as FTX and Terra has highlighted the importance of adopting measures that protect users. One such measure, which can be used by global digital asset market makers such as DWF Labs, is the so-called pump-and-dump protection scheme. The scheme is basically a technique for managing liquidity across the exchanges.
Meanwhile, Grachev also shared his views on topics ranging from misunderstandings about market makers to how market making differs between centralized exchanges (CEXs) and decentralized exchanges. Here are the managing partner’s answers to the rest of the questions from Bitcoin.com News.
Bitcoin.com News (BCN): Can you briefly outline the making of the market as well as what happens when a user buys a crypto asset on a centralized exchange or sells it on a decentralized exchange?
Andrey Grachev (AG): The market maker creates liquid markets, bid order books (places specific buy and sell orders in order books) and maintains the spread. In simple words – market makers create tradable markets. [Decentralized exchanges] DEXs (especially those based on automated market maker) are a bit more limited in terms of market making tools, but even here – the market maker maintains sufficient liquidity level via AMM [automated market maker] It collects and does some additional work in order to maintain the same price level across centralized and decentralized exchanges.
Because market makers make money by differentiating the bid and ask prices, based on a given bid, the market maker will [for instance] Coinbase token sale a little bit [basis] pips (bps) higher than on DEX and sell tokens on DEX a few pips (bps) cheaper than on Coinbase.
BCN: What is a common misconception about market making?
AG: This is very close to a conspiracy theory: while the token is going up, the market maker is pumping; While the token is dropping, the market maker is dumping. Do you know that situation when you bought something and then it immediately went down? The same. The market maker took a look at your position and traded against you.
The reality is quite different – the market maker holds liquidity on both sides (buying and selling) and keeps a small spread. More advanced orders can also take limited orders from the order book in order to improve the market and increase organic volumes.
BCN: Is market making different between decentralized exchanges and centralized exchanges?
AG: I would break it down a little differently – ordering books based on (could be CEXes and DEXes) and Other (only DEXes. Includes AMMs on DEXes and Focused Liquidity on Uniswap V3).
Exchanges based on order books allow market makers to use different order types (limit, spot or cancel, market, etc.) in order to create a market and provide liquidity or take it from the books.
AMM is less flexible because trades occur in pools of liquidity. The biggest challenge for AMMs is maintaining the same price in DEXes as their centralized counterparts by adding or removing liquidity as needed. They also constantly monitor large and predatory trades to mitigate their impact.
Concentrated liquidity is similar to AMM, but it allows traders and market makers to define the price range to provide liquidity. It offers more flexibility compared to AMM, but it is still less flexible than book-based platforms.
Given that advanced market makers use their own proprietary systems for operations, most of them, including DWF Labs, interact with DEXes via a virtual order book that is simulated based on blockchain transactions, AMM status, and pools of concentrated liquidity.
BCN: How has the collapse of FTX and Alameda Research affected market makers and how is the market dealing with the crypto liquidity crisis? Also, are whales now wary of trading large volumes?
AG: First of all, all the right market makers had money on FTX, because it was unavoidable to trade on the second largest exchange in the crypto world. Some of them were badly damaged and collapsed. Many others are going through a difficult financial situation right now.
Overall, it’s a very sad event, but good in the long run. The market is driving out companies that weren’t sustainable enough to operate during the storm. As a result, the market will be healthier.
In terms of whales and trading volumes, we’re seeing a lot of activity in the over-the-counter (OTC) market as the exchange’s liquidity has dropped dramatically since the crash. For example, the same icons that you used to only see [a] A price drop of 10-12% after a $500,000 sell order wouldn’t even be able to accommodate a $100,000 sell order now without prices crashing by 60-70%.
Fortunately, the market is recovering. We have been seeing this positive dynamic since the beginning of January 2023.
BCN: There is an idea among some of the founders of the project that liquidity is not a function of the market but a function of marketing. In fact, some founders believe that making sure that there are enough buyers for their token sellers is enough to solve their liquidity issues. How true are these assertions?
AG: This is true and not true at the same time. Without marketing, liquidity is somewhat inactive and artificial. If no one trades or trades rarely, this will prompt the market maker to correctly anticipate price deviations and will need to increase the spread in order to maintain an acceptable level of risk. This can lead to a death spiral – the spread gets worse and the volume drops even further, resulting in an even worse spread.
In another scenario, suppose the project is entirely dependent on organic traders. It’s possible – Bitcoin started without any market makers and it was fine. But that success may be difficult to replicate.
Traders go to the market and have a wide range of symbols available for trading. If we are talking about developing a token – it probably has a poor market structure even with good marketing. why? Because compared to market makers, organic traders trade by their own insight rather than quantitative models. This makes spreads wider and execution speed slower because retail orders must match each other, rather than being bought and sold by the market maker immediately. For example, DWF Labs has a 40-70% market share of trading volumes for many tokens and if our formations were removed from those markets the volumes would collapse.
BCN: Some players in the market have incorporated what is known as pump and dump protection. Can you briefly explain what this is about and how market makers use this to ensure participants are safe in the event of extreme price volatility?
AG: If we rule out really dramatic events like the FTX market crash or Terra LUNA when the selling pressure was insane and no one could help, we would see that market makers mitigate price movements by managing liquidity across the exchanges. In 99% of cases, pumping or emptying is carried out in a particular exchange and then expanded to other places like the plague. If it’s not too exciting, the plague can be prevented by fixing the price on a particular exchange. If it doesn’t work, the market makers let the price figure out naturally, and maintain the relevant depth of market around the spread.
BCN: On the surface, making a market looks like making a smartphone where the products on offer are seemingly indistinguishable. So how do market makers differentiate themselves from competitors?
AG: [The] Times market makers can introduce a simple order book building bot. Market makers play an important role in the markets. We are not visible, but without us the market would be less efficient and the spreads would be on a much wider scale.
I also believe that the right market maker is also the right partner, advisor and sometimes investor who can leverage his knowledge and relationships with exchanges, funds and portfolio companies in order to move the project forward and allow it to grow. DWF Labs only builds relationships with projects in this way, acting not only as a market maker but also as a partner. Like I said, it’s like the smartphone industry, but there is only one Apple even in the smartphone industry.
BCN: It is often said that many projects are wary of launching their tokens in a bear market. Is this true (and if so, does it make sense)?
AG: There are two sides to every single coin. During a bull market, a project can rise at a massive valuation, get listed on exchanges with a large market cap, and be pumped even further by the market. Most of these projects collapse once the market turns into a downtrend. It is difficult to survive and meet the expectations of investors, especially when the reality of the earth is lagging far behind.
Compared to bull markets, bear markets have some beauty. Yes, it is true that fundraising is more complex and the valuation is usually smaller. But when the project goes to an exchange with a small capitalization, the market is likely to push it and then stabilize. Then given the fact that the project went to the market when everything was being sold at low valuations, the market can only turn to the upside – which will push the project up and give it additional chances of success.
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