The Liquidity Problem

Any exchange is a marketplace for buyers and sellers. If everybody wanted to buy and nobody wanted to sell, there would be no trades. Conversely, if everybody wanted to sell and nobody wanted to buy, then again, there would be no trades.

The issue faced by all exchanges is one of Liquidity. When you want to sell your token, there needs to be somebody else who is willing to buy your token at a price that is acceptable to both of you. It is not always the case that two traders want to take an opposing view of a given asset (buy vs. sell) at exactly the same price and exactly the same time. Without this, we just have emptiness. To be clear, on an illiquid exchange you will likely find worse prices as a result of the sparsity of offers and wider spreads.

An exchange without liquidity is like a barren land

Investopedia describes the general problem of liquidity very well.

Exchanges need somebody who is willing to be the first person to name a price to buy or sell an asset. This brave soul could be very wrong on how they have priced their offer and could end up selling their asset for much less than what it is worth — or buying it for much more than it is worth. Moreover, this daredevil could end up waiting for hours without anybody coming along to trade with them. As risky as this sounds, there are some that choose to do this — and find a way to make money while doing it!

Enter the Market Maker

The market maker is an entity that is consistently one of the first to name a price to buy or sell an asset (using a “maker” offer) in the hopes of making a profit on the spread or when reversing the position they hold.

Wikipedia defines a market maker as such:

A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn.

When you name a price on a market that is empty you are posting an offer to the order book, i.e. you are placing a “maker” offer. In doing so, you are allowing someone to trade with you at a price of your choosing. However, if someone trades with you by placing a “taker” offer, they will have made that decision to trade with you after knowing that you are willing to trade with them.

In other words, when placing a “maker” offer you are revealing to the broader market your intentions of demand (or supply). Others could factor this in when thinking about the price of the underlying asset and could possibly exploit your offers for their own profit (and your loss). Thus, by placing a “maker” offer you are always incurring what is known as adverse selection — when others with more material information trade with you to exploit your trading strategy.

Why then, would someone take on the role of the market maker?

Armed with the ability to set the prices on the market, the market maker would typically quote a higher ask price than their bid price (as opposed to using the same price). That is, they would maintain a spread so that if both their bid and ask offers are executed then they would be left with a profit equaling the spread, assuming the same order size for both offers. There are many considerations to take into account when setting this spread, such as the fee on the exchange, existing trading volume, cost of capital, assets being traded, asset inventory risk, counterparty risk, current market volatility, etc.

A seasoned market maker would be able to evaluate the above risks and come up with a price at which to buy and sell the asset pair, and therefore the spread they can afford to offer on the given market. Thus, market makers are compensated for the liquidity they provide on the market in the form of profits from the spread or from reselling the assets they acquire as part of their market-making activities.