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Market Making in Crypto Exchanges: An Introduction

Market makers at stock exchanges are companies or individuals who stand ready to buy and sell securities. Similarly, market makers at crypto exchanges sell and buy crypto assets on a continuous basis at a publicly quoted price. Since everbody can place an order at crypto exchanges, like e.g. Binance or BitMEX, and order execution is managed automatically, everyone can easily become a market maker. From the perspective of traders, market makers are great, since they help to find counterparties. But what is the incentive to be a market maker? How do they make a profit from providing liquidity?

Basic Concept

Similar to exchange bureaus offering foreign currencies at a sell and buy price, also assets have a sell and buy price. Crypto exchanges employ an order book to organize trades, and on both sides — sell and buy side –, two types of orders can be made: market orders and limit orders. Limit sell orders specify the quantity and the ask price — the minimum price for which the maker is willing to sell her assets. Limit buy orders have a bid price which is the maximum price the maker agent is willing to buy a certain quantity of the asset. On the other hand, market orders just specify the asset quantity a trader wants to sell or buy. These trades get executed immediately against the best limit orders on the market. Everytime a market maker buys and sells assets through limit orders, i.e. her limit orders get filled, she makes the profit characterized by the difference between the ask price and bid price – which is called the spread. 

A Bit More Formal 

An approximative model of market making in limit order books can be taken from the seminal work of Avellaneda and Stoikov. The agent in this model is the market maker who proposes bid and ask quotes for an asset pair, e.g. imagine BTC/USDT. These bid and ask quotes are denoted by \(S_t^b\) and \(S_t^a\) which are sent to the order book at time \(t\). The reference price \(S_t\) of the as...

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