All You Need to Know About Automated Market Makers and Why Crypto Needs Them

If you’ve ever bought any asset using an exchange, crypto or otherwise, then the speed of your trade settlement depends on liquidity, which in turn depends on market makers. After all, the trading process is dependent on your order having a match – if you’re buying, then a counterpart needs to be selling. Therefore, exchanges rely on market makers to ensure liquidity. 

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Here, we explain how market making works and how they can help the issues of market manipulation in crypto.

Back in the Day…

Before Bitcoin, before any kind of online trading exists, trading took place on the floors of stock exchanges. To ensure price transparency and discovery, each exchange had to maintain a manual order book showing all of the buy and sell orders, along with quantity and price. Those responsible for the order book would match buyers with sellers. The role of market making evolved to facilitate the order matching process. A market maker effectively acts as a kind of buying and selling service for trading. Traditionally, they did this on a for-profit basis, by asking for a higher sell price than the bid they made on the buy. However, with a manual order book, there was always inevitably some price slippage in the time taken to complete the entries. Furthermore, humans as market makers, have another downside – manipulation. Once the markets started implementing trades using automated market making algorithms, together with online trading, the human effort became significantly reduced.

Automated Market Makers – The Good, the Bad and the Ugly

Automated market makers changed the landscape of trading. Because trading bots react instantly to even the tiniest price changes, the markets became exponentially more fast-paced, with less price slippage while waiting for trade settlement, and increased liquidity. Fast trading without the human element also has its downsides. Traders are generally in it for the money, so financial markets have become subject to increasing regulation to prevent traders and exchanges from engaging in acts that will manipulate the markets, such as spoof or wash trading. However, now we add cryptocurrency markets into the mix. Whereas traditional stock markets still tend to follow the working day, cryptocurrency markets never sleep – trading happens 24/7, all over the world. Together with a lack of regulation, crypto trading represents a market climate that’s ripe for manipulation. This perfect storm is what led to the news earlier this year that up to 86% of crypto exchange trading is fake. One exchange owner even disclosed that for around a $1000 payment from an exchange, wash trading firms will inflate an exchange’s trading volume to the tune of millions. Unfortunately, many crypto exchanges rely on these shady tactics to put on a show of liquidity rather than the sophisticated practices employed by traditional markets to ensure they remain compliant with regulations.

How Can the Crypto Industry Solve This?

Using automated market makers to replace unethical trading practices and help improve liquidity is one way that the exchange industry can step up its game. Bancor is one project that has made strides in this area, pioneering the concept of the liquidity network together with Relay Tokens which use smart contracts to hold funds in reserve.

Guaranteed Liquidity with Relay Tokens

In the Bancor protocol, the Relay Token acts as a kind of market maker. The Relay Token holds two token balances in its contract which serve as reserve funds. This allows traders to convert between the two tokens, according to values calculated in real-time by the smart contract. When a token is purchased, the reserve supply diminishes, and the token goes up in price. When it’s sold, the reverse happens. In this way, liquidity is guaranteed, but importantly, the market making mechanism is on a non-profit basis. This means the spread between bid and ask is kept tight. The founders of Bancor came up with this innovative concept in response to market demand, with over 150 tokens integrated to the platform across both the Ethereum and EOS blockchains. At the time of the Bancor ICO, it was the biggest in history, raising over $150m. Since Bancor blazed the trail on the concept of liquidity networks, others such as Uniswap have followed suit.

AI-enabled Smart Contracts

Another solution is using AI-enabled smart contracts to optimize the management of supply and demand. This is one feature of Fetch.AI, which has just launched a new innovation called Synergetic Smart Contracts. These are smart contracts which go beyond the usual “if-this-then-that” logic of today’s smart contracts. They enable decentralized solutions to complex coordination problems involving supply and demand, such as market making. Synergetic Smart Contracts can be deployed to generate market orders that maximize returns, based on various market making strategies. Such a toolkit and framework opens up an entirely new model of liquidity and market making not only within the cryptocurrency markets but also for real-world commodities. If you plan to trade regularly, then it’s critical that you have an understanding of how markets and market makers work. Whichever exchange you use, the liquidity will depend on its market making strategy. Falsely inflated trading volumes manipulate prices for the entire markets, not just the exchange engaging in these practices. Therefore, like all crypto-related decisions, do your exchange homework carefully.

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Disclaimer: This article is a guest submission and was not authored by BeInCrypto or any of its staff members. It has been published on our website because we believe it may be of interest to our readers.