In this article of QuantVan Academy, we are going to discuss:
- who and what is a market maker (liquidity provider)?
- what is the usage of market-making in security markets such as cryptocurrencies?
- Why should exchanges collaborate with a market maker in order to liquidate the pair?
- and in general, what is liquidity?
What is the market maker?
Radcliffe: A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn
as being said, a market maker is trying to place simultaneous bid/ask open orders surrounding the last trade price in order to buy at lower prices and sell as much at higher.
while a market maker can make money using this strategy, it also helps with the liquidity as the liquidity provider fills the order book with orders.
What is Liquidity? why does it matter?
investopedia: Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market at a price reflecting its intrinsic value. In other words: the ease of converting it to cash.
The most liquid asset is Cash. however,tangible assets, such as real estate, fine art, and collectibles, are not all liquid. Other financial assets, ranging from equities to partnership units, fall at various places on the liquidity spectrum.
Why is liquidity important in cryptocurrencies?
Within the past 10 years, the number of cryptic coins rose drastically. As coinmarketcap mentions, in 2019 there are more than 2319 active coins. There are many exchanges around the world that try to make trading of these coins available. This means there are so many pairs that are not liquid enough for an investor. Thus, exchanges try to liquidate all their assets using a market maker to do the market making tasks.
How do market makers provide liquidity?
There are many articles and papers such as this one, in which they mention Bid/Ask Spread as a metric to measure the liquidity.
Bid/Ask Spread is the gap between the best price of a buyer and the best price of a seller. As this gap deducts, the liquidity encreases. liquidity providers try to place orders inside the Bid/Ask gap in order to deduce the gap.
An increasing number of researchers around the world argue about the number of fake orders in exchanges. We also covered how to measure Bid/Ask Spread in this article of QuantVan as a liquidity metric. There is also another liquidity metric commonly called a price gap and is being used to measure liquidity in crypto pairs.