Definition: A market maker (or liquidity provider) is a person or program which buys and sells tokens and securities. In contrast to “normal” traders a market maker is always available for buying or selling. Its purpose is to provide permanently liquidity and allow other traders to buy and sell at a market price.
A market maker can be run by the exchange itself or act independently. In some cases an exchange assigns this task to a third party.
If a market maker runs out of stocks it can either stop its operation or short sell the requested stock.
How a Market Maker Earns Money
The typical business model of a market maker is to earn a profit on the margin between buy and sell price (bid and ask spread). The market maker tries to buy as cheap as possible and sell as expensive as possible.
If a market maker is commissioned by an exchange it also can earn a commission.
Advantages of Market Makers
There are some advantages of market makers over order books.
Traders can permanently buy or sell, if they accept the price of the market maker. They don’t need to wait for another trading partner and they don’t need to be matched.
Disadvantages of Market Makers
Market makers also have some disadvantages or short comings.
- They don’t have infinite liquidity (although in some cases like continuous tokens they do)
- Market makers can manipulate the market.
- Market makers are a centralized instance which can impede certain traders
- Beside that market maker have the opportunity of front running by selling (or buying) their own assets first in a falling (rising) market. They can also predict, if the price of a certain stock will rise of fall by knowing the outstanding orders.
- Another, although mostly illegal practice, is naked short selling where a market maker sells securities without even having them. This in some cases comes close to fraud. With such methods a market maker can push the price of a stock down as the “assumed” supply rises.
Types of Market Makers
There are different types of market makers
- Programs (Automated Market Maker)
- With access to other exchanges and their prices
- Without access to other prices. Instead following an own stock price function
Market Makers in Cryptocurrencies and DeFi
In decentralized Finance (DeFi) automated market makers play a vital role. They either supply continuous tokens (continuous tokens are created on demand) or act as a decentralized exchange between two tokens or a crypto currency and a token. In the Decentralized Finance (DeFi) space they are a way to make centralized middleman redundant. Beside that they allow normal users to contribute to the market by providing liquidity to the liquidity pool.
Here, mostly Scoring rules and Constant Functions are applied in order to calculate the price.
Manipulation by market makers: https://www.imanet.org/-/media/4c6c7650a0024853a1c61963d7865649.a