Editor's Note: This article comes fromCrypto Valley Live (ID: cryptovalley)Editor's Note: This article comes from

Crypto Valley Live (ID: cryptovalley)

Crypto Valley Live (ID: cryptovalley)

, Author: Mona El Isa, translation: Ling Jie, reprinted with authorization from Odaily.

For those who don't know me, my background (before Melon) was as a market maker and trader at Goldman Sachs. Around 2008, I spent nearly a decade making markets in some of the most liquid and illiquid stock markets, including pricing several multibillion-dollar blockbuster trades."I also had the privilege of witnessing the birth of the first Automated Market Makers (AMMs) about 15 years ago. At the time, many of us feared that AMM would make our jobs redundant. Of course, they did result in some traders being made redundant. But guess what, today there is still a team of market makers with traders on the trading desks of every major brokerage firm at Goldman Sachs and Wall Street."There is a lot of hype around AMMs in both CeFi and DeFi. However, these dreams don't really match reality. The dream is that AMMs will completely replace human market making; the reality is that AMMs can only serve markets that are already liquid, they cannot work effectively in markets that are very illiquid, which means there are limits to automation.

outside

Some of the nuances and softness of market making (OTC MM), which help explain why AMMs do not scale effectively.

This is important because there is reason to believe this presents a particular challenge for DEXs. Don’t get me wrong, AMMs definitely have a role to play in handling high flow orders. But in the end, we will never see DEX liquidity truly flourish without greater participation in the OTC trading market to process less liquid orders.

secondary title"What is a market maker?"A market maker is a price provider that absorbs liquidity from buyers and sellers. If someone has a large amount of assets and wants to buy or sell, it is the market maker's job to give them a price at which they can liquidate their position in one go. In extreme cases, block trades (very large volumes) can take a lot of time to price and require the opinions of multiple specialists in the underlying asset."As a trader, the usual practice is to ask several market makers for quotations. At this point, you can decide which party offers you the best deal and make a deal with them. Sometimes traders do not reveal in advance whether they are buyers or sellers. Instead, what they asked for was"two-way price

party

(i.e. are they a buyer or a seller). This is a common approach to avoid the front running problem.

In short, a market maker is about determining a price (regardless of size), resulting in a trade, and dealing with the risk associated with that price in a sustainable manner.

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Automated Market Making (AMM)

Automated market making is a subset of market making. It involves an algorithm that automatically provides transaction prices through inputs. The traditional market-making sector came up with the concept of an automated market maker nearly 20 years ago. Generally, these algorithms handle market making based on small and liquid orders. For example, limit the maximum size of allowed transactions.

A Key Word About Liquidity

DEXs are struggling to find solutions to the lack of liquidity. But what exactly does that mean? Liquidity refers to the ability to move large positions in a token without affecting the price too much. For any given asset, liquidity is an inverse function of size. We must understand that no matter what asset it is, there is always a scale beyond which trading liquidity will disappear, which is very important."OTC "Let's look at a few examples:

Example 2: Let's look at MLN. You might think MLN is highly illiquid with a market cap of $4 million and CoinmarketCap reporting $500,000 in volume on the exchange over the past 24 hours. However, if I told you that I have been privately making markets, regularly building $150,000 worth of MLN blocks, and

For settlement, you may have a very different idea. Currently, data sources like CoinmarketCap do not capture overall cryptocurrency trading volumes because there are no post-trade reporting requirements.

Hopefully you now have some understanding of the concept of liquidity. We will come back to the method of measuring liquidity later in the blog. It can also be seen from the above examples that information is the key to market making. What kind of information do you need?

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What constitutes a market?

1. Volatility: The volatility of an asset is a statistical indicator (ie, standard deviation) to measure the distribution of asset returns. In most cases, the higher the volatility, the riskier the security. If you know what the daily implied volatility of an asset is, you can calculate how likely it is to deviate from the current price, for example, if TokenX is trading at $10, the daily implied volatility is 5% , you can infer the following:

2. Liquidity: There are different ways to measure liquidity, but when I think about the liquidity of a trade, I think it refers to how many days it can take to clear a position with minimal price impact. I would define minimum impact as 20% of volume (although this may vary by asset)."market"For example, if someone offers a price of 10 million KNC tokens, and the average daily trading volume is only 1 million KNC tokens, then you need 10 days of trading volume. Assuming you can close your position with minimal market impact, at 20% of volume - you could take 50 days to close your position in the market. This is a long time to hold KNC tokens, which means you should price in a higher risk when making markets.

3. Your market share & influence: If your market share is high, you will naturally have more information about current/recent buyers and sellers. This can give you the advantage of matching buyers and sellers with minimal risk = better prices = minimized trade risk (maybe even a profitable trade!). This is the ultimate holy grail of market makers: being able to match buyers and sellers at a price with zero trading risk (double volume = double commission). When you have a high market share and are known by a specific name

market

, you will naturally be able to find the other party to the transaction faster."5. How easy is it to hedge? : Hedging refers to a position taken to reduce the risk of adverse price movements of an asset. Typically, hedging involves taking an offsetting position (as opposed to a market maker's position) in a highly correlated asset (or basket of assets)."and"6. The reputation of the counterparty: In general, every market (including highly regulated markets) has"good actor

and

bad actor

. Due to the lack of a reliable reputation system, there is more room for bad actors to exist in DeFi. If a buyer exhibits the pattern of a bad actor, then they are likely to cause losses to the market maker. Market makers price bad actors much less than good actors and are not competitive. It's that simple.

7. Recent price and volume: Today's price and the recent performance of the asset are also useful information for market makers. Are there many buyers/sellers and does the asset feel overbought/oversold? Is there any reason? If there is a big move and you can understand the reasoning behind it, that usually gives you an advantage. But if you don't understand it, it's a red flag for you.

9. Inventory and Positioning: If you are really proficient in a certain asset pair, you should become quite good at predicting price movements in that asset pair. If you have a high belief in the appreciation of BTC against ETH, then you can start anticipating your market making flows ahead of time and adjust your inventory to prepare for the arrival of buyers. This will allow you to price more competitively with minimal profit and loss impact. This can be what attracts market share and gaining an edge (remember market share = volume = commission = profit margin)."risk"As you can see from the list above, all listed inputs give you

risk

Information. This information can help you make the market. The quality of the price will determine the level of your market maker, which will be reflected in your profit and loss (trading profit and loss + commission).

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Market making in DeFi — automatic market making and manual market making

As of now, DeFi AMMs simply cannot function in the absence of liquidity in the market.

The purple part of the table above is an illustration of a market maker in DeFi. The quotation is based on the reference price ETH/USDC 212.5 on May 8, 2020. I looked up what I would get if I sold 20,000 ETH/USD on the Kraken order book to compare to what I got from Uniswap, 1inch, DEX AG, and Paraswap (these are all aggregators who provide liquidity through aggregated AMMs and order books) Compare the returns obtained by selling 20,000ETH/USDC.

I put Kraken in this table to illustrate a problem. Kraken is not actually a market maker, but an order book matching exchange. This is important because as an order book matcher, Kraken's job is not to provide liquidity, but to facilitate the orderly placement and matching of limit orders. However, unlike order makers, market makers are supposed to be providers of liquidity, so if they do their job well, their prices should be more attractive than those on all the order books out there!

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So, where are the OTC market makers in DeFi?

Although protocols like Kyber and 0x have spent a lot of time building the infrastructure for OTC market making, we still haven’t seen OTC market making fill this liquidity gap.

Finally, people may not be aware of the soft factors and nuances involved in market makers (and thus not pay as much attention to them), or they may recognize the limitations of technology in replicating these soft factors and thus focus AMMs on flows that already have sex market.

in conclusion

It's obviously much more trendy these days to say you've built a fully automated market maker. But this does not solve the liquidity problem in the short term!

secondary title

in conclusion"A"To sum up, AMMs currently account for a large part of DEX's liquidity, but they only work on liquidity transactions. They can only function where there is already liquidity, so by definition they are not really market makers. Market makers should create liquidity when there is no liquidity, while automatic market makers can only provide liquidity when there is liquidity.