Cryptocurrency was founded on the principle of decentralization, which states that there should be no mediator between two people trading assets in a trust-less manner.
It has been extremely interesting to watch the rise of centralized exchanges (CEXs) such as Coinbase, which went public on the legacy stock exchange NASDAQ and operates a centralized order book, provides custody to clients, steps in when necessary, holds all manner of personal-identity information, and conducts the kinds of KYC and AML checks that are typically expected of traditional banks and financial institutions. But there is a different kind of bitcoin financial venue that has gained in popularity in recent years: the decentralized exchange (DEX). As a result, it is much more consistent with the original idea of cryptocurrencies, and therefore far superior. Services such as Uniswap, Sushiswap, the aggregator 1inch, and Bancor are examples of what we’re referring about.
There are no gatekeepers, no custody, and no need to open an account, unlike Coinbase, Kraken, Bitstamp, or any other CEX.
Incentivizing its users to provide liquidity and establish their own markets, these companies run trading platforms on top of the Ethereum or Binance Smart Chain blockchains, respectively. Consider the Uniswap cryptocurrency, which is built on the Ethereum blockchain. It has already grown in size to be about half the size of Coinbase, according to some estimates. Uniswap’s governance token, UNI, gained traction at the turn of the year 2021, rising by more than 1,180 percent between January and March, pushing the company into the top ten most valuable cryptocurrency projects by market capitalization, according to CoinMarketCap.
As of September 2021 Uniswap offers 8,278 trade pairs, greatly exceeding the number given by CEXs such as Coinbase, Binance, and Kraken. The truly innovative part about Uniswap is that it allows anyone to construct their own market and give owners a venue to trade their cryptos back and forth using a market maker that is automated (AMM).
Market makers (also known as market making services) have been active in the world of financial trading (such as foreign currency, stocks, and futures) for a long time, but they have only recently achieved a well-deserved position in the hierarchy of traders. Their significance is undeniable since they are an essential component of the financial ecosystem, providing structure and flow to trade activity.
What is Market Making?
An exchange’s order book is used by market makers to create a healthy and active market for both buyers and sellers by putting a large number of limit orders in the order book of the respective exchange. Market-making institutions are registered and have typically signed a formal arrangement with an exchange. On the one hand, such an arrangement offers them preferential trading conditions, including cheaper fees, but on the other side, it obligates market makers to provide a specific level of liquidity. The depth of an order book and the magnitude of the spread are two indicators of the quality of liquidity available on various exchanges.
Many market makers are brokerage firms that offer trading services to investors in order to maintain financial markets liquid. A market maker can also be a single trader, sometimes known as a local. The great majority of market makers work on behalf of large institutions due to the magnitude of securities required to support the volume of purchases and sales.
Market makers are already prevalent on any well-known exchange that cares about turnover, such as the NASDAQ or NYSE.
Despite the fact that market makers now trade electronically, in a developed stock market, their job is filled by High-Frequency Trading institutions, which hire the greatest quantitative finance professionals in the world to develop the most sophisticated trading algorithms. As market making gets more popular and ubiquitous, the value it brings to the trading business becomes more apparent. However, market makers’ services continue to leave a significant portion of the market untapped.
Each market maker displays buy and sell prices for a certain number of shares. When a market maker receives a buyer’s order, they instantly sell their position in shares from their own inventory. This permits them to finish the order. The act of creating markets serves to keep financial markets running smoothly by making it easier for investors and dealers to buy and sell securities on the open market, to put it simply. If there is no market making, it is conceivable that there will be insufficient transactions and that investment activity would be reduced or eliminated.
A market maker must commit to quote prices at which it will purchase (or bid for) and sell (or ask for) securities on a continual basis
Market makers must also specify the number of trades they are willing to make as well as the frequency with which they will quote at the best bid and best offer prices. Market participants must adhere to these guidelines at all times, during all market forecasts. Market makers must remain disciplined when markets become inconsistent or volatile in order to continue facilitating seamless transactions.
Market Making in Crypto Finance
Given the cryptocurrency market’s nascency, there aren’t many market-making organizations working in it. Furthermore, due to its decentralization, asset prices may differ dramatically across several exchanges. Disparities can be seen, particularly on small and medium-sized exchanges that do not use market makers’ services. As a result, in the absence of market making, cryptocurrency prices are quite likely to diverge from their market price. Price differences across exchanges may push clients to sell their bitcoins for less or acquire them for more than they would ordinarily do on other, larger exchanges.
Crypto Finance automates the whole transactional process as a result of this fact. In the early days of cryptocurrency, traders were eager to trade between the increasing number of assets that were becoming accessible. However, order books were unable to keep up with the demand for liquidity from both investors on either side of the transaction. Automated Market Makers were created to address this liquidity issue.
Historically, conventional market making has only been profitable when it has been used to issue buy and sell orders in the most popular assets (such as timber, silver, or biotech stocks) because there is no incentive for a market maker to maintain a large inventory of assets (such as timber, silver, or biotech stocks). This produces significant illiquidity in less well-known firm shares, such as those with smaller market capitalizations. It’s the same in the crypto world.
There is no liquidity and no way for us to profit from rising or falling prices if the coin or token I possess is not traded on Coinbase, Binance, or Kraken. Individuals may deposit cryptocurrency assets into an Ethereum smart contract, which then automates the market making process for them. Uniswap and other DEXs enable anybody to deposit cryptocurrency assets into an Ethereum smart contract.
How does an AMM work?
Digital assets may be exchanged without the requirement for prior permission via the use of automatic market makers (AMMs), which automate the process by using liquidity pools rather than a traditional market of buyers and sellers. The use of AMMs is becoming more common. On a typical trading platform, buyers and sellers offer a variety of prices for the same product. When other users find a stated price acceptable, they enter into a transaction, and the price at which the transaction is completed becomes the asset’s market price. The trading of stocks, gold, real estate, and the majority of other assets is based on this basic market structure.
Trading assets is approached differently by AMMs than it is by other types of traders. In the context of Ethereum and decentralized finance, AMMs are a kind of financial instrument that is unique to the platform (DeFi). In contrast to traditional buyer-seller interactions, this new technology is decentralized, constantly accessible for trade, and does not rely on third-party middlemen to facilitate the transaction. In this cutting-edge method of transferring assets, the principles of Ethereum, Bitcoin, and blockchain technology in general are embodied: no one entity has authority over the system, and anybody may develop and participate in innovative solutions to issues that already exist. Users of AMM platforms trade against a liquidity pool of tokens, rather than directly between buyers and sellers, as opposed to traditional trading platforms. A liquidity pool is, in essence, a collection of tokens to which everyone has equal access. In exchange for putting their tokens into liquidity pools, users may earn a percentage of the tokens in the pool according on a mathematical formula published on the Ethereum blockchain. By modifying the formula, it is possible to optimize liquidity pools for a variety of applications. A liquidity provider is anybody who has access to the internet and has ERC-20 tokens of any kind, and who makes their tokens available to an AMM’s liquidity pool. Liquidity providers are usually compensated for their services by charging a fee to the pool. Traders who participate in the liquidity pool are required to pay a charge. Using a technique known as “yield farming,” liquidity providers have lately been able to collect yield in the form of project tokens from their customers. AMMs have risen to become the main method of exchanging assets in the DeFi ecosystem, and it all began with a blog post by Ethereum co-founder Vitalik Buterin on “on-chain market makers,” which was published in 2012.”
Currently, there are three prominent AMM models: Uniswap, Curve, and Balancer.
The pioneering technology of Uniswap allows users to construct a liquidity pool using any pair of ERC-20 tokens in a 50/50 ratio, and it has become the most durable AMM model on Ethereum and in the DeFi Space.
As a result of Curve’s expertise in putting up liquidity pools of similar assets, such as stablecoins, it is able to provide some of the lowest rates and most efficient transactions in the industry, while simultaneously addressing the issue of restricted liquidity in the marketplace. Most importantly and most significantly, Balancer expands the capabilities of Uniswap by allowing users to build dynamic liquidity pools that may include up to eight different assets in any ratio, thus increasing the flexibility of asset management methods.
The world of crypto finance is being taken over by automated market makers. Finally, there is a reason why people choose Ethereum and Bitcoin over other cryptos. Despite the fact that Automated Market Making is a new technology, variations of it have already shown to be a crucial financial tool in the rapidly evolving DeFi and Crypto Banking ecosystem and an indication of a maturing crypto sector overall.