Encryption Market Makers: Driving Market Prosperity, Crossing Bull and Bear Cycles of Hermits

Summary

The market maker business in traditional finance began to take shape in the early 19th century and has now developed into a mature stage characterized by a diverse range of trading products and relatively stable business and revenue. As important participants in the financial market, market makers play a unique role in providing market liquidity and market efficiency. With the continuous expansion of market size, more and more institutions and investment banks have joined the market-making business, becoming an important source of income. The overall market-making business is also concentrating towards the leading players, creating intense competition. In order to capture market share and customers, market makers are continuously upgrading their algorithms, technology, risk management, and compliance, and are gradually getting involved in the encryption field.

The market-making business in the encryption market is not fundamentally different from traditional finance. However, there are significant differences in operation models, technology, risk management, and regulation. First, in terms of market size, the encryption market is relatively small compared to traditional financial markets, and the scale of market makers in the encryption industry is also relatively small. The liquidity in the encryption market is relatively low and the volatility is high, requiring market makers to be more cautious in risk management. Second, the market-making teams in the encryption market are also referred to as "庄家". Due to the difficulty in regulating the trading process in the encryption market and the lack of a strict market-making system, the relationship between trading platforms, project parties, and market makers becomes more complex. Additionally, market-making activities are not only generated on centralized trading platforms but also involve on-chain market making, leading to the emergence of middleware and protocols that serve market-making. Lastly, in terms of technical architecture, the encryption industry needs to possess higher technical capabilities to ensure the security of transactions.

The market-making business in the encryption market is a blue ocean, providing opportunities for every investor but also accompanied by risks. Currently, the U.S. Securities and Exchange Commission ( SEC ) and the Commodity Futures Trading Commission ( CFTC ) are tightening regulations on the encryption market, affecting many institutions and businesses. Additionally, with the bear market trend, large institutions frequently face defaults, making risk management for market makers even more challenging. Furthermore, encryption market makers are also facing issues such as market fragmentation/interoperability, low capital efficiency, regulatory uncertainty, and the still-improving exchange technology/connectivity.

Even so, encryption market makers still have significant room for growth and profit. In the future, encryption market makers will also show some development characteristics of traditional financial market makers: ( ) market participants are gradually diversifying; ( ) market varieties are diversifying; ( ) business leverage is high; ( ) the head effect of market makers is becoming more and more obvious. In the investment field, attention can be paid to centralized small market maker strategies or service projects, tools solving interoperability, and CeDeFi projects.

1. Traditional Market Maker Track

Market makers refer to institutions or individuals who provide liquidity in financial markets. Their main responsibility is to provide liquidity and market depth for the securities trading market. Market makers typically conduct transactions between buyers and sellers in the securities trading market and provide quotes so that other traders can buy or sell based on those quotes. Market makers are usually composed of investment banks, securities firms, or professional institutions, and they play a crucial role in maintaining market stability and liquidity. Market makers often trade simultaneously in one or more markets and provide liquidity by buying and selling the same asset, thereby offering trading opportunities for market participants.

The main goal of market makers is to profit from price differences during asset price fluctuations, so they often use algorithms and other techniques to analyze the market, find opportunities, and execute trades quickly. Market makers may trade in various markets such as stocks, foreign exchange, commodities, and bonds.

1.1 Industry Overview

1.1.1 Industry Functions and Services to Clients

The role of market makers in financial markets is very important, distinct from other market participants. Especially in providing liquidity and market efficiency. Specifically, market makers undertake six main functions:

• Provide liquidity: Provide liquidity between buyers and sellers to make the market more active.
• Continuous Quotation: Market makers provide continuous quotations, offering buying and selling prices at any time to facilitate market participants in trading.
• Managing Risks: Market makers need to manage trading risks, maintain a healthy risk-reward ratio, and protect their own and their clients' interests.
• Provide consultation: Market makers can provide market information and analysis to help clients make better trading decisions.
• Increase market efficiency: The presence of market makers can enhance market efficiency, reduce the spread between buyers and sellers, and improve the efficiency and competitiveness of the market.
• Provide innovative products: Launch new products based on market demand to meet the diverse investment needs of customers.

The clients of market makers mainly include the following categories:

• Traders: Market makers provide liquidity to traders, helping them execute trades quickly and efficiently.
• Investment Institutions: Market makers provide liquidity and services to investment institutions, helping them with asset allocation and risk management.
• High-frequency trading firms: Market makers provide liquidity and services for high-frequency trading firms, helping them execute fast and high-frequency trades.
• Retail investors: Market makers provide liquidity and services for retail investors, assisting them in trading financial products such as stocks and futures.
• Other financial institutions: Market makers also provide liquidity and services to other financial institutions, such as banks and insurance companies.

1.1.2 The development history of the market maker track

The development process of the market maker track can be divided into five stages:

• Before the 19th century: The initial stage of market making involved facilitating transactions in traditional over-the-counter markets. The market making system is one of the oldest securities trading systems, originating from traditional OTC markets. Traders, in order to facilitate transactions and reduce trading costs, took on the role of market makers themselves, providing bid and ask quotes to other traders or clients, mostly communicating through traditional means such as face-to-face discussions and telephone communications.

• 19th century to 1970s: Standardized trading platforms emerged and developed rapidly, with market makers providing liquidity in the on-exchange markets. After the 19th century, major trading platforms in the United States, such as the Chicago Stock Exchange, were established. At that time, market makers were primarily active on the New York Stock Exchange (NYSE). During that period, market makers primarily relied on manual trading rather than computer programs. Market makers would post buy and sell quotes on the trading book of the stock exchange, providing market liquidity based on these quotes.

• 1970s-1980s: With the development of computer technology, market makers began to gradually adopt electronic trading systems, making trading faster and more efficient. In the 1970s and 1980s, the trading volume of market makers grew rapidly, and their trading strategies and technologies continued to innovate and optimize.

• 1990s: In the late 20th century, institutional investors and retail discount brokers emerged, and the market share of internal matching platform trading by market makers continued to rise. On the one hand, the rise of institutional investors such as mutual funds and pension funds led to a significant increase in the demand for block trades, while large investment banks represented by Goldman Sachs had a relative advantage in providing comprehensive services to institutional investors in the market-making business related to block trades; on the other hand, retail discount brokers such as Robinhood and Charles Schwab experienced a surge in retail trading volume, and these discount brokers mainly routed orders to market maker platforms in exchange for payments from market makers known as Payment for Order Flow. With the globalization of financial markets, market makers began to expand their businesses globally, while also facing increasingly fierce competition. During this period, market makers started to adopt more complex and advanced trading strategies and technologies to improve trading efficiency and profitability.

• 21st Century: With the continuous innovation and development of financial markets, the role of market makers has gradually expanded and consolidated. In the 21st century, market makers began to enter emerging markets, such as the cryptocurrency market and options market, while also adopting more advanced technological means, such as artificial intelligence and machine learning.

(# 1.1.3 Market Size and Competitive Environment

According to data from the financial industry regulator FINRA) and the Financial Industry Regulatory Authority###, as of September 2021, the number of registered legal market makers in the United States exceeded 500. These market makers are registered with FINRA and are regulated by them. According to the Office of the Comptroller of the Currency(OCC), from 2012 to 2018, the total trading revenue of U.S. bank holding companies remained around $50 billion, although some years, represented by 2018, saw a decline in trading revenue year-on-year due to secondary market conditions, the overall fluctuation was small and showed a growth trend. Since 2019, trading revenue in the banking industry has further increased, with total trading revenues for U.S. bank holding companies in 2019, 2020, and 2021 being $75.126 billion, $79.512 billion, and $78.946 billion, respectively. The size or market share of market maker companies is often related to the level of liquidity they provide in the market. Specifically, the market share of market makers can be measured by the following indicators:

• Trading Volume Ratio: The trading volume ratio of market makers in a certain market can reflect their trading activity and influence in that market.
• Quote depth: The quote depth of a market maker in a certain market, that is, the quantity and price at which they are prepared to trade, can reflect the extent to which they provide liquidity in that market.
• Trading Efficiency: The trading efficiency of a market maker in a certain market, which refers to their ability to execute trades quickly and efficiently.

In summary, the market share of market makers is an important indicator that can reflect their performance in terms of trading activity, liquidity provision capability, and trading efficiency in the market.

The following are some of the more well-known market-making companies:

• Jane Street: A quantitative trading firm headquartered in New York City, USA, established in 2000, primarily focusing on trading in stocks, futures, foreign exchange, and other areas.

• Citadel Securities: A financial company based in Chicago, USA, founded in 2002, it is one of the largest market makers in the world, primarily involved in trading in stocks, futures, foreign exchange, bonds, and other fields.

• IMC Trading: A financial company headquartered in Amsterdam, Netherlands, founded in 1989, is one of the world's leading market makers, involved in trading in stocks, futures, foreign exchange, and other areas.

• Optiver: A financial company based in Amsterdam, Netherlands, established in 1986, it is one of the largest options market makers in the world and also involved in trading in other areas.

• Susquehanna International Group: A financial company based in Philadelphia, USA, established in 1987, it is one of the largest options market makers in the world and also engages in trading in other areas.

• Jump Trading: A quantitative trading firm based in Chicago, Illinois, USA, established in 1999. The company is dedicated to using advanced algorithms and technology to conduct trading in search of profit opportunities. Jump Trading is involved in various markets globally, including stocks, futures, foreign exchange, and digital currencies.

( Necessary conditions for market-making companies 1.2

Establishing a market-making company requires strong financial strength, technical capabilities, and market insight, while also meeting the regulatory requirements of financial regulatory agencies. Additionally, in the face of a highly competitive market environment and significant risk management pressures, the difficulty is quite high.

)# 1.2.1 Understand the Market

Market makers need to have a deep understanding of market rules, liquidity, trading varieties, and traders' behavior patterns in order to make correct trading decisions. They need to understand the trends and opportunities in the market to gain an advantage. The methods for understanding the market include the following several:

• Research market information and data: Market makers need to study the historical and current trading data of the market in order to understand.