Cryptocurrency Liquidity Provision Case Study

Liquidity Provision in the Traditional market

Overview

In the traditional financial market, it is difficult for investors to find trading counterparties due to insufficient liquidity or imbalance of certain underlying assets, resulting in unable to meet the demand, and market functions are subjected to certain restrictions. Therefore, the traditional financial market introduced a market maker system to provide liquidity and improve market efficiency. The market maker system refers to a transaction method where an institution with a certain solidity and credibility, at a price level that it is willing to, with its own capital or securities or other financial products, constantly quoting to other traders the bid/sell prices of certain underlying assets and also accepting the bid/sell quotation price requirements of other dealers to ensure timely transactions.

Since the law of each exchange and the region is different, the conditions for becoming a market maker are also different. Previously, exchanges such as Nasdaq, CME, CBOE, HKSE, London Stock Exchange and other exchange have extensively adopted market maker system, in China’s continental futures and options markets, inter-bank markets and the NEEQ have also introduced them. The main functions of traditional financial market makers are:

• Maintaining market liquidity: Investors can buy or sell the underlying assets at any time according to the market maker’s quotation, and will not be unable to trade because the market is only buying or selling.
• Maintaining the stability and continuity of market prices: After researching the value of the underlying asset, the market maker makes a quote based on market supply and demand, which can reduce price fluctuations to a certain extend.
• Inhibiting price manipulation: Market makers generally have strong capital and follow-up financing capabilities, as well as high-value analysis and judgement capabilities, and conduct transactions on this basis, thus making price manipulators hesitant.
• Facilitate price discovery: Market makers have certain information advantage and also able to provide other market participants with certain price information.

Case Study

Take the securities 50ETF options market as an example. The Shanghai Stock Exchange selects institutions with a relatively strong scale and practice as options market makers among various securities companies. The selected securities companies need to have staff, capital, system, policy and etc to be well-equipped then market-making activities only can be carried out.

Option market makers need to perform their quotation obligations on indicators such as the largest bid-ask spread, the smallest number of quotations, continuous quotation participation rate, contract coverage rate, maximum response time limit for quotation, and response quotation participation rate. At the same time, it also enjoys the right to raise the position limit, reduce the transaction handling fee, and exempt quotation under certain circumstances. A complete process of options market making can be divided into three steps:

• Determination of the benchmark price: For each option contract, the market maker will determine the market-making benchmark price, which is the theoretical value of the option contract. For example, “50ETF Purchase February 3500” in the market, the market maker calculates according to the theoretical model and figures it should be worth 0.3036 CNY per share, then its benchmark price can be taken as 0.3036 CNY per share.
• Bid and Ask pending orders: The market maker will set the spread based on factors such as market risk in actual transactions, current inventory and target inventory, the margin of safety and etc, with the theoretical price as the emphasis, determining the bid and ask price separately and the order volume. For example, for “50ETF Purchase February 3500” 10 ask orders at 0.3059 CNY per share were listed on the above, and 10 bid orders at 0.3023 CNY per share on the other side.
• Risk Management: Market Makers adjust their quotation strategies in a timely manner based on the current market situation to reduce the overall portfolio exposure to directional risk and volatility risk. Usually, in market-making transactions, they perform a delta neutral hedge when their own positions accumulate to a certain level. For example, assuming that the Delta value of the MM‘s position is negative, then buying the corresponding share of 50ETF spot can complete the Delta hedge, causing the Delta of the entire new portfolio remains neutral. In addition to delta risk management for MM transactions, Market makers also need to perform risk management for combined Vega, Gamma, Theta, and VaR indicators at the same time.

Liquidity Provision in the Digital Asset Market Space

Overview

In the field of digital asset trading, the role of market makers is particularly important. In an extreme case, the FTX exchange was derived from the famous market-making team Alameda Research. Since digital assets are still in the early stages, some lower-tier exchanges, or a large number of lower-tier assets, due to the smaller share of audiences/participants, retail investors alone cannot build a relatively reasonable trading market (enough liquidity). At this moment, liquidity providers are needed to provide liquidity for the platform/trading pair.

With the development of the industry, especially the prosperity of Defi, Automated Market Makers (AMM) have begun to appear and become popular. The most popular ones are Uniswap, SushiSwap and so on.

Centralized exchange Liquidity Providers (Case Study)

Wootrade

Wootrade is a liquidity provider platform designed to solve the issues of inadequate liquidity in digital asset exchanges, as well as the high trading fees and insufficient transaction depth of the original liquidity solutions. Most of the liquidity of the digital asset market is concentrated on the top-tier exchanges. Third-tier exchanges are facing the liquidity problem of mainstream tokens. Wootrade hopes to aggregate exchange liquidity, internal liquidity pools and rely on Kronos’ MM strategy to provide better depth, lower cost, and lower risk.

In 2019, Wootrade was incubated by Kronos Research, a digital asset trading company. The high-frequency strategy of the quantitative base Kronos can guide the order size and ensure Wootrade’s internal liquidity. According to the projects, the two are completely independent, but both have the same founders.

Wootrade currently only supports To B transactions accessed through APIs and was open to exchanges, wallets and institutional clients. According to the projects, since the launch of Wootrade 1.0, more than 10 exchanges and institutional clients have been accessed, including Hoo, Tongzhou Capital, MOV, Injective Protocol, DODO, MXC, Gate.io, Bitmart and etc. Once the trading platform and wallets are connected, they can connect to Wootrade’s liquidity to improve transaction efficiency. Institutional customers can directly trade through the Wootrade platform.

Wootrade Orders Routing, Source: Wootrade, TokenInsight

Woo Token

Wootrade’s native token is WOO, and it is planned to be used as a margin for trading accounts after issuance; it provides token rewards for nodes; it is used for pledge and payments, etc.

The maximum supply of WOO is 3 billion, of which 50% is reserved for the ecosystem, which will be jointly managed by the projects, the customer and the community, vesting unlocking rules are carried out in a profit-incentive manner, but the specific unlocking methods and ratio is not yet released by the project team. Equity investor holds 0.68%, accounted for 20% in the ratio compared with the amount hold by the project team; Advisors holds 5%; Private and Public sale account for 20%, currently Seed round investors hold 8.78%, Private sale round accounts for 8.28%, the number for IEO will not exceed 0.5% of the maximum supply, and the remaining unsold portion will be placed under the liquidity management scheme, which accounts for 5% of the original plan plus the number of unsold tokens, which are managed by the project and are mainly used to provide liquidity in the sub-market.

VRM

VRM is a proprietary HFT company founded in August 2018, it focuses on trading AI-based quantitative HF strategies on the crypto market and provide MM solutions to digital asset exchanges. The company works on all major trading venues, such as BitMEX, Bitflyer, OKEx, Huobi, Binance, Derebit, Bit.com, Bithumb, Liquid, BTSE with a market share ranging from 6.2% to 49% each, their daily average trading volume is around 15 Billion USD. In addition, VRM has multiple businesses in its ecosystem including VRM Research, VRM Capital Management, VRM Mining and etc.

The company’s core teams are all from different countries. Among the partners, Andrei Grachev from Switzerland has 11 years of BD experience, Vladimir Demin from Russia has experience as an exclusive consultant from Huobi, Shawn Chong from China is responsible for businesses in the SEA market. Yoichi Akase from Japan is in responsible for BD of BlackOcean, Raymond Campbell from the US has more than 25 years of programming experience and is responsible for the company’s IT, and Gytis Kandrotas from Estonia has 4 years of BitMEX experience, is responsible for the company’s UIUX.

BlackOcean is a liquidity and Dark Pool project powered by VRM. This product can provide a quotation and matching services for large orders and retail transaction orders with a single value more than 100k USD or 5BTC. The transaction price is provided by professional market makers and liquidity providers based on market conditions. The software development work for this project started in August 2020 and was completed in December 2020.

Dark Pool and Liquidity Pool of Black Ocean, Source: VRM. TokenInsight

FLY Token

FLY is the native token of the project BlackOcean, which can directly deduct the transaction fee within the system. At the same time, holding a certain amount of FLY can provide up to 25% discount for dark pool transaction in BlackOcean, and be able to access the liquidity pool for trading. In addition, Fly can also be used in multiple businesses of VRM, which includes:

Usage of Fly Token, Source: Fly Whitepaper

The total issuance of FLY is 1,701,170,600, which 18.2% is held by institutional investors-locked up to 24 months; the advisor is allocated 2%-locked up to 18 months; 14% is allocated to the project team, which is locked up to 48 months. The rest, 17% is allocated to customers, 30% used in liquidity management, and 18.8% is allocated to incentive programs.

Decentralized exchange liquidity providers – AMM

Different from the traditional order book form, AMM uses a liquidity pool model to execute market making. The asset price in the asset pool is determined by the platform’s function, which means the price of the trading pair in AMM is directly related to the reserve of its trading asset in the asset pool. Therefore, once a transaction occurs, the reserve of the transaction asset in the asset pool will change, and the actual transaction execution prices of the asset will change, resulting in slippage. So, the larger the transaction size, the deeper the destruction of the liquidity reserve of the liquidity pool, resulting in a higher slippage as well.

The height of the AMM slippage also depends on the nature of the mechanism is uses. First, slippage does not exist under the constant sum market maker function; that is, X and Y represent the reserves of the two assets in the asset pool, K is a constant, and the slippage is 0 when X+Y=K (straight line in the figure below). However this mechanism will lead to the exhaustion of asset liquidity, which Y will be 0 when X is large enough, and vice versa, so it is not used in actual applications.

To prevent the liquidity of the liquidity pool from drying up, transactions must be punished by slippage. Take Uniswap which uses a constant product MM system (X*Y=K) and Curve that mixes constant sum and constant product MM as an example, their function graph is shown as the dashed and solid curve in the figure below. It is known that the slippage is 0 when the line is straight in the figure below. Therefore, the slippage becomes smaller when the curve fits the straight line. Curve focuses on trading pairs with stablecoins and asset prices at 1:1 ratio, making it possible to reduce slippage, but at the same time, this mechanism cannot be applied to trading pairs with violent price fluctuations, otherwise, the cost of arbitrage will below under the low slippage situation, which easily leads to liquidity exhaustion.

Different AMMs of DEXes, Source: Cruve

In addition, as the AMM capital pool must use a large amount of liquidity and idle capital to ensure that the asset price is still competitive after the slippage occurred, the low utilization rate of capital has become another problem of AMM, and due to the income of LP comes from the transaction fees of the actual transaction. This problem directly affects the income of LP. In addition to lowering slippage can bring better prices to traders, it can also bring more transaction fee income to LP.