How to establish a market-making system in the cryptocurrency market?

1. Background

Market makers, also known as market makers, are merchants who create markets for financial products by providing buy and sell quotes, and specialize in providing liquidity for financial markets. Market makers in traditional financial markets refer to securities operating legal persons with certain strength and credibility as licensed dealers, who continuously quote the buy and sell prices of certain specific securities to public investors (i.e., two-way quotes), and accept the buy and sell requests of public investors at that price, and conduct securities transactions with investors with their own funds and securities. Market makers maintain market liquidity and meet the investment needs of public investors through such continuous buying and selling, and buyers and sellers do not need to wait for the counterparty to appear. As long as there is a market maker to act as the counterparty, the transaction can be concluded. The market maker market includes two types: "complex" securities trading markets (such as the New York Stock Exchange and the London Stock Exchange) and "single" securities market maker markets (OTC markets). Since my country has long implemented a planned economic system, there is a serious lack of understanding of the market maker system, especially the market maker system in the financial field, resulting in only the OTC capital market in China. However, the government does not have a clear and long-term development plan for the OTC market, nor has it given active support policies to the spontaneously formed OTC market among the people, resulting in the domestic OTC capital market lagging seriously behind the development of the real economy.

2. Market Makers in the Cryptocurrency Market

Market makers in the cryptocurrency market usually refer to dealers. Currently, market makers in the cryptocurrency market submit buy and sell orders as customers to provide liquidity to the market. Because the cryptocurrency market is not like the traditional financial market, except for the "Announcement on Preventing the Risks of Token Issuance and Financing" (hereinafter referred to as the "94 Announcement") jointly issued by multiple ministries and commissions on September 4, 2017, my country has no more laws to regulate cryptocurrency market transactions, nor does it have a strict market maker system to constrain it like the traditional financial market. The public dealers who are subject to the market maker system in the traditional financial market are market makers. After the release of the 94 Announcement in China, ICO projects can no longer be carried out in China. Therefore, in order to enhance market liquidity, stabilize currency prices and market value management, ICO initiators introduced professional market maker teams to enter relatively friendly countries to make markets. In order to improve market liquidity, some exchanges also released market maker plans to attract market makers.

3. Risks faced by cryptocurrency market makers

There is no perfect market maker system in the cryptocurrency market. As mentioned above, market makers submit buy and sell orders as clients to provide liquidity to the market. They usually face the following risks: First, model risk. Model risk is also called pricing risk. It determines whether market makers can provide attractive prices, and whether the pricing is correct or not is directly related to the market maker's profit and loss. Second, inventory risk of huge fluctuations in asset prices. If the price of the underlying asset develops in a unilateral direction, for example, in an upward trend, the sell order is executed but the buy order is not executed, the risk of rising selling prices will be borne. In a downward trend, the sell order is not fully executed after the buy order is executed, and the risk of falling buying prices will be borne. Third, the Poisson distribution of buy and sell orders causes trading risks. Whether in exchanges or OTC, the frequency and quantity of buy and sell orders are random, which may cause the risk that the buy order has not been fully executed after the sell order is executed. Fourth, market competition risk. The more cryptocurrency market makers there are, the stronger the competitiveness. In order to obtain more market-making spread income, market makers compete with each other to narrow the quoted spread.

IV. Suggestions on the market-making system of the cryptocurrency market

Based on the risks of current cryptocurrency market making activities, the cryptocurrency industry needs to learn from the traditional financial market making system to establish its own market maker system, and cryptocurrency market makers should also set strict strategies and disciplines to avoid possible risks. Specifically:

First, focus on the quality of transactions rather than the quantity. The key to effective trading for cryptocurrency market makers is to choose the quality of transactions rather than the quantity of transactions. Not all types of markets can make the current market making strategy useful. Swing trading performs best in strong trends, while automatic scalping is often more effective when the market is stable. Therefore, cryptocurrency market makers usually determine the appropriate trading strategy based on the correct market adjustments to find high-quality transactions.

Secondly, there is a suitable exit mechanism. The high volatility of cryptocurrencies determines that market makers need to set stop-loss lines to ensure the sustainability of market making. Market makers usually increase positions in strong trends and can also lock in profits by expanding forward. When the market plummets, if stop-loss is not set, the usual operation strategy may result in a total lock-in. However, when prices change too quickly, stop-loss is not always effective, and due to slippage, it may not be very effective.

In addition, market makers should conduct reasonable inventory risk management. Generally speaking, in the market maker system, the inventory volume and inventory risk are positively correlated. The larger the inventory volume, the greater the risk, and the correlation between inventory volume and price changes is the greatest; when there is an expectation of price increase, the inventory volume increases, and when there is an expectation of price decrease, the inventory volume decreases. However, when the price is really at a high level, the inventory volume tends to decrease, otherwise, the inventory purchased at a high price will tend to depreciate as the market price decreases, and the inventory risk increases. Therefore, in order to reduce this risk, market makers will tend to reduce inventory for cryptocurrencies with a larger price increase. In this sense, the inventory volume is negatively correlated with the price of cryptocurrencies. In addition, the inventory volume is positively correlated with the market maker's own capital.

Finally, do not overuse leverage. Market makers often use leverage to increase order size, but if too much leverage is used, once the strategy is not suitable for the current market, the loss will also be magnified year-on-year. Therefore, as a market maker pursuing more stable returns, leverage should not be set too high.

At present, the Chinese government's selection of market makers in the non-cryptocurrency field is subject to approval, which is very restrictive. As for the cryptocurrency market, due to the release of Announcement 94, many domestic financial institutions are unable to participate in cryptocurrency market making. If traditional financial institutions want to participate, they still need to wait for the regulators and the cryptocurrency industry to jointly establish a compliance mechanism that conforms to the characteristics of this industry.

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