Introduction: Liquidity reigns supreme
Liquidity is the most important characteristic of a well-functioning Secondary market. Liquid markets will allow your project’s stakeholders to trade tokens efficiently and may also positively influence community-wide sentiment for your protocol. In the time immediately following your TGE up until your protocol achieves a sufficient degree of decentralization, bootstrapping Secondary market liquidity needs to be a top priority.
Robust "organic" liquidity is unlikely to exist for newly listed tokens. If you are not proactive in scaling liquidity, you will negatively influence your token’s performance and therefore minimize the ability of token incentives to help scale your protocol.
To support secondary market liquidity, we strongly encourage you to engage an external trading institution known as a “Market Maker.” Three major types of Market Makers collaborate with blockchain projects:
- Designated Market Maker (“DMM”)
- Principal Market Maker (“PMM”)
- Self-Service Market Maker (“SSMM”)
The three types of Market Makers listed above are service providers. These service providers operate within a niche we refer to as Market Making as a Service (“MMaaS”). Notable institutions that operate in MMaaS are:
- GSR
- Wintermute
- Jump Trading
- Efficient Frontier
- Flow Traders
- Amber Group
- SkyNet
- GotBit
- CoinLiquidity Solutions (“CLS”)
- Digital Wave Finance (“DWF”)
- Kronos Research
MMaaS business models and trading strategies differ significantly from strategies employed by traditional Market Makers. We'll discuss each type of MMaaS business model in greater detail in the section: Partnering with a Market Maker.
The content to follow will cover a variety of topics before assigning tasks. We will discuss the following topics:
- Why should you partner with a MMaaS before your TGE?
- What are the major business models that MMaaS employ in their engagements with projects?
- What are the incentives related to each business model employed by MMaaS?
- What strategies can you leverage to structure a more balanced and equitable relationship with a market maker?
Before we dig in, let’s cover some of the basics.
What is liquidity & why is it so important?
Simply put, liquidity is the appetite of patient buyers to purchase an asset, and the appetite of patient sellers to sell an asset. Liquid markets allow investors, protocol participants, and traders to buy & sell what they want, when they want, with minimal transaction costs.
The presence of patient traders providing liquidity allows others to trade aggressively, with immediacy, and minimal market impact. In this sense, individuals that provide liquidity create positive externalities in the marketplace.
Poor liquidity conditions can catalyze an awful user experience for stakeholders aligned to a blockchain project. Buyers can’t buy and sellers can’t sell without adversely moving the market. Market impact causes rampant volatility and may catalyze negative price performance despite no meaningful change to a protocol’s fundamentals or underlying issues with the project itself.
What are the main ways to provide liquidity, and what do they look like?
When an order to provide liquidity is placed by a buyer or seller on a traditional centralized or decentralized exchange (“CEX” or “DEX”), the order is categorized in a file called a continuous limit order book (“CLOB”). When it comes to visualizing a CLOB and the liquidity organized within it, the most common illustration is a depth chart. A depth chart is a representation of cumulative buy-side and sell-side depth for an asset at various price levels. See below for a visualization of liquidity being provided on a CLOB depth chart:
The green area of the above depth chart shows patient demand to buy a token while the red area shows the patient supply of sellers. The Y-axis shows the quantity of tokens and the X-axis shows the price per token.
When liquidity is provided on a CEX or DEX powered by an automated market-making (“AMM”) protocol, the assets are submitted into a liquidity pool (“LP”). At its core, a liquidity pool is a shared pot of tokens. Instead of trading at defined prices as you would on a CLOB, users on an AMM swap directly with the LP. The price of the tokens involved in the swap is determined by a mathematical formula. The most common formula popularized by Uniswap is:
tokenA_balance(p) * tokenB_balance(p) = k
or
“x * y = k”.
visualization of x * y = k.
The constant, represented by “k” means there is a constant balance of assets that determines the price of tokens in the LP. For example, if an AMM LP holds Token ABC and Token XYZ, every time Token ABC is bought, its price increases as there is less ABC in the pool than there was before the purchase. Conversely, the price of Token XYZ goes down as there is more XYZ in the pool than there was before the purchase. The LP stays in constant balance, where the total value of Token ABC in the pool will always equal the total value of Token XYZ in the LP.
Why do people provide liquidity?
People provide liquidity because they expect to profit. While liquidity is often perceived as a public good that benefits all market participants, no one provides liquidity out of altruistic intentions.
We assume all market participants are rational, and that anyone that trades expects to benefit from doing so, or at the very least, no one that trades actively wants to “lose” simply for the benefit of others in the marketplace. People who provide liquidity are not "white knights". They expect to profit from their trading decisions.
Accordingly, providing liquidity can be very profitable for sophisticated traders. Institutions that specialize in generating profit from providing liquidity are known as Market Makers.
What is a (traditional) Market Maker?
A Market Maker is a profit-motivated trading institution that will, quite literally, “make a market” for others to interact with by placing bids and offers for others to trade against. A majority of the liquidity on any exchange – whether it is powered by a CLOB or an AMM – is provided by Market Makers. The patient willingness of Market Makers to provide liquidity lays the foundation for others to trade what they want, when they want, without adversely moving the market. Market Makers are the “invisible hand” of financial markets. For most mature assets, odds are you’ll trade against one of them if you are aggressively buying or selling.
Market making is a capital-intensive business. Institutions must allocate a sizable balance sheet to provide liquidity if they wish to generate any meaningful profit. Even then, the profit generated from this type of trading activity is relatively small compared to the amount of capital deployed. The key to any Market maker’s strategy is consistency, sustainability, and risk aversion. At scale, and over time, Market making can indeed be a lucrative business for a savvy institutional trader.
How do (traditional) Market Makers (and others) profit from Providing Liquidity?
Traditional Market Makers generate profit by interacting with takers. Whereas Market Makers provide liquidity in a patient manner, takers remove liquidity in an aggressive, impatient manner. The mechanisms through which Market Makers generate profit differ based on the type of exchange that they provide liquidity. For example, a Market Maker is incentivized to provide liquidity on a CLOB because they can “buy low” when their bids are filled by an impatient seller, and “sell high” when their offers are filled by an impatient buyer, profiting as a result. Buying low and selling high on a CLOB is a type of trade activity referred to as “capturing the bid-ask spread.” The spread is the difference between the price of the best bid and the best ask, or simply the difference between the price you would pay if you sought to buy or sell an asset immediately on a CLOB.
Trading in this manner many times throughout the day can generate a favorable revenue stream for the Market Maker as long as others are willing to trade against their liquidity.
Illustration of a Market Maker capturing the bid-ask spread by trading against two takers.
In the above example, Alice the Market Maker trades against Retail investors Bob and Carol. Bob accepts a discounted price to sell his tokens to Alice. At the same time, Carol accepts a premium price to purchase from Alice. Bob and Carol are willing to accept a lower price to transact immediately. In contrast, Alice was rewarded for her patience with the ability to buy and sell at favorable prices. Alice essentially profits at the expense of Bob and Carol given that trading is “zero-sum”. In other words, the total accounting gains of the winner (Alice) are exactly equal to the total losses of the losers (Bob & Carol).
To summarize, Alice provided liquidity because she expected to profit. Alice is not an altruist. While her liquidity did indeed present opportunities for Bob and Carol to trade, her willingness to provide that liquidity was entirely dependent on her expectations of profiting at their expense.
Market Makers prefer to trade on exchanges with high trade volume from uninformed takers (retail traders). They seek to be the “winners” in the zero-sum game of trading – profiting either from capturing the bid-ask spread on a CLOB, or farming yield through fee distribution on an AMM.
What are the risks associated with (traditional) Market Making?
Market Makers lose money when market conditions force them to buy at high prices and sell at low prices. Because Market Makers trade in a patient manner, they bear three distinct types of risks:
When prices move away from their orders, Market Makers fail to trade and wish that they had. Market Makers can minimize execution uncertainty by aggressively pricing their limit orders to increase the probability that they will trade (i.e., “tightening spreads”).
The risk that the market will move against the Market Maker after their order has been executed. This happens when prices move toward and through their limit prices (i.e., the price depreciates and falls below an order to buy, or the price appreciates and rises above an order to sell). The market maker has an order fill, and the market subsequently moves against their newly established positions so that they lose money (i.e., incurring an on-paper loss).
The risk that the Market Maker’s assets used to provide two-sided liquidity (i.e., “inventory”) will depreciate in value due to overarching macroeconomic trends. For example, a market maker providing liquidity on a BTC/USDT order book must hold both BTC and USDT in their inventory. They will use BTC to provide offers (i.e., orders to sell) and USDT to provide bids (i.e., orders to buy). If the price of BTC depreciates due to an overall bearish shift in market wide sentiment, the dollar value of the market maker’s BTC inventory will decline. This risk takes the form of “impermanent loss” when a Market Maker operates on an AMM. Impermanent loss impacts Market Makers when they provide liquidity to an LP, and the price of their deposited assets changes compared to when they first deposited them. The bigger this change is, the more the Market Maker is exposed to impermanent loss.
The risks of execution uncertainty and ex-post regret incurred by Market Makers are compounded as they trade with better informed traders. Accordingly, Market Makers only provide liquidity when they are confident that they can recover from uninformed traders what they expect to lose to informed traders. They naturally try to avoid informed traders. If a Market Maker finds their liquidity is consistently filled by informed traders, they will widen spreads and thin out the depth of their orders in an attempt to avoid the “toxic” order flow.
The threat of inventory risk means that Market Makers are more likely to provide liquidity for assets where they can firmly assess fundamental value and overall marketplace dynamics. This means that Market Makers tend to stick to "mature" assets rather than long-tail "altcoins".
This provides the Market Maker with greater confidence that their orders to buy and sell an asset accurately reflect “fair value.” For example, a market maker is more likely to provide liquidity for bitcoin rather than a newly listed token. This is because the marketplace for bitcoin is widespread, dynamic, and transparent (i.e., there is lots of trade activity across many liquidity venues and an abundance of information available to assess pricing trends) whereas the marketplace for a newly listed token is likely constrained with minimal transparency (i.e., there is low trade activity across a small number of liquidity venues with low levels of information available to assess pricing trends).
To summarize, the more widespread demand exists from uninformed takers to buy and sell a crypto asset in an aggressive manner, the more lucrative it becomes for a Market Maker to provide liquidity. An absence of uninformed takers means that a Market Maker is unlikely to profit from providing liquidity and therefore becomes more beholden to fluctuations in market prices driving inventory PnL, rather than efficient trading driving trading PnL, which represents a misalignment with their core business model.
Why doesn’t liquidity exist organically for newly issued tokens?
The main reason why Market Makers don’t provide liquidity for newly issued tokens is because the expected value of doing so is unattractive. Expected value is defined here as anticipated monetary returns (or losses) that can be generated over time from providing liquidity. Unattractive expected value means that Market Makers believe one of three things:
- Expected value is less than $0 (i.e., the Market Maker expects to lose money by providing liquidity).
- Expected value is uncertain (i.e., the Market Maker cannot accurately assess the potential PnL from providing liquidity).
- Expected value is lower than the expected value of activities the Market Maker is currently allocating capital to.
Two major phenomena exist in the marketplace for newly issued tokens. Together, these phenomena tend to make the expected value of providing liquidity significantly unattractive for Market Makers.
An inability to assess fair value means that a Market Maker may significantly overestimate or underestimate the price of the token and therefore misprice the quotes of their buy and sell orders. An inability to approximate fair value is caused by (i) underdeveloped fundamentals or a lack of transparency on fundamentals, and (ii) a lack of widespread, robust price discovery.
Immature markets tend to feature (i) low trade volume from a small number of individuals, (ii) wide spreads and thin liquidity, and (iii) a small number of trading venues (i.e., listed on a small number of CEX and DEX CLOBs and AMMs). As mentioned in the previous section, an absence of organic trade activity means that a Market Maker is unlikely to profit from providing liquidity. Given that Market Making is inherently capital intensive, an institution is unlikely to deploy its inventory to provide liquidity in an immature marketplace if there are alternative opportunities to profit from trading in more established marketplaces.
In sum, the (1) inherent difficulty of pricing newly issued tokens, along with (2) the immature nature of their Secondary markets results in an unattractive expected value for prospective Market Makers. Given that Market Makers are not altruists and they will only provide liquidity if they expect to profit from doing so, they tend to avoid trading newly issued tokens. Due to a lack of Market Makers, the marketplace for newly issued tokens is generally illiquid with low trade volume.
What happens if a token has poor liquidity?
The previous section should make it clear that the market for newly issued tokens is illiquid with low trade volume. A common misconception from blockchain projects is that marketplace metrics such as liquidity and volume are unrelated to their protocol functionality and therefore have no impact on the future success of their project. This couldn’t be further from the truth. A lack of liquidity can negatively influence a token’s performance and therefore erode the monetary value of token incentives. Without token incentives, most protocols will struggle to achieve widespread decentralization. There are three major ways that a lack of liquidity can impact a token:
First, a lack of liquidity can result in runaway price depreciation of your token. For example, a lack of bid-side liquidity from patient buyers means that even small orders to sell your token will have significant market impact. Dramatic price shifts and large “red candles” on a trading chart may be perceived by existing token holders as deteriorating fundamentals, or a “flaw” in the underlying protocol. As a result, they may sell their tokens as well, thus catalyzing further price depreciation.
Second, illiquid markets are prone to low trading volumes, which are unlikely to attract speculative traders or convince new exchanges to list your token. Since buyers and sellers cannot trade at efficient prices, they are unlikely to interact; therefore, no trades are consummated and no volume is conducted. With no promise of revenues from trading fees, CEXs are unlikely to list your token if it has low trade volume. Furthermore, many CEXs will de-list tokens with poor liquidity and low volume due to the poor user experience they provide their customers. DEX Liquidity Pools are also unlikely to attract liquidity given that minimal fees are generated from swaps, thus resulting in minimal revenue share to liquidity providers via yield farming.
Finally, illiquidity can cause large discrepancies between your token’s price and its fair value. Most blockchain communities rely almost solely on price as an indication of a token’s utility and the fundamental value of its associated network. For example, many retail speculators interpret token price appreciation as growth in the value of the underlying protocol due to increased usage or technological development. This is concerning given that prices often diverge from fundamental values. Reliance on price as the sole indication of fundamental value can create a virtuous cycle between token price action, perceived value, sentiment, trading decisions, market impact, and further price action. See below for an illustration of this virtuous cycle:
This virtuous cycle can lead to significant decoupling of price and fundamental value to the point that almost no one in the market has any logical indication of what the “fair” price for a token might be. This is a cause for concern because the dramatic swings in price that may catalyze this virtuous cycle are often a consequence of natural buying and selling pressure in an illiquid marketplace, rather than any meaningful change in a token’s fundamentals or utility. In other words, the virtuous cycle begins at Stage 4 (e.g., purchasing a token based on an expectation of future growth) rather than Stage 1 (e.g., token price appreciation).
In sum, a lack of liquidity may cause the rampant decoupling of price and "fair value" for your token and your protocol.
In other words, your development efforts to scale your protocol and grow the value of your token’s utility may be conducted in vain given that your token’s price is the only thing people care about, and its performance is influenced almost entirely by natural buying and selling, rather than evolving or deteriorating protocol value.
What are the benefits of liquidity for your native token?
The previous sections should have made two things abundantly clear: first, organic liquidity is unlikely to exist for your newly issued token, and second, a lack of liquidity is a bad thing for your token and can negatively impact the performance of your protocol. It should be clear that taking a laissez-faire approach to Secondary market liquidity is not strategic for a blockchain project. If you’re still reading, we assume that you’re interested in taking a more proactive approach to bootstrapping liquidity. Here are some of the main benefits of doing so:
Investors are rational actors that seek to maximize returns – they are unlikely to build a large position in your token (or any asset for that matter) if there is uncertainty surrounding the ability to exit an investment quickly and at stable prices. A liquid marketplace for a token positively influences investor sentiment because it provides reassurance that an investor can sell (and buy) without moving the market significantly.
Tight spreads allow investors and traders to transact in small quantities of your token at efficient prices; therefore, empowering them to trade when they deem it prudent to do so. In contrast, wide spreads discourage buyers & sellers from trading due to inefficient costs.
Liquid markets allow buyers and sellers to interact without inducing significant volatility. This means that a token’s price is more likely to reflect its fair value.
Once the Secondary marketplace for your token is proven to have trading activity, more is bound to follow. Interaction between makers and takers catalyzes a self-enforcing cycle that can continually improve liquidity conditions – attracting organic market participants to begin trading your token purely from a profit-seeking perspective.
Tasks
Evaluate the simulated liquidity conditions for your project based on your projected market capitalization. See how adjusting the liquidity conditions from "Excellent" to "Poor" impacts market impact and price performance.
Make a rough estimate on your anticipated liquidity conditions after listing (we'll dive into this concept more in the sections to follow).
The first chart shows a simulated order book "depth chart" for your token. Forgd has modeled this order book based on projects with a similar market capitalization to what your token is projected to have after its simulated post-TGE "pop". Your ability to achieve "excellent" or "great" liquidity conditions will largely be influenced by which exchanges you list on and what market makers you collaborate with.
The second set of charts Illustrate your token's estimated price performance in terms of US dollars and market capitalization. While there is no way to predict post-TGE token price performance with absolute certainty, we leverage a quantitative model that mimics daily price discovery based on a project’s unique Tokenomics in a fully dynamic capacity. We do this by calculating the US dollar value of “patient” and “impatient” buyers & sellers on a daily basis to determine a “start of day” and “end of day” price. The resulting token price from the initial simulation influences the appetite of each side to transact in the next day’s simulation; therefore, price becomes both an output as well as a dynamic variable in the model.
The model accomplishes this by first converting supply from Token Distributions & Emissions Schedules and demand from your project’s Demand Drivers (utility and demand mechanisms) into US Dollar terms. Next, we subtract the supply from the demand to determine the net buying or selling pressure from impatient traders. Positive figures indicate more buyers than sellers while negative figures indicate more sellers than buyers. We then simulate market impact by taking the resulting net buy/sell pressure and trading it against a dynamic liquidity pool that represents patient buyers and sellers. The resulting “slippage” induced by the simulated trade is then multiplied by a “starting price” to determine an “end-of-day price.” The resulting “end-of-day price” is then used to determine the US dollar value of supply & demand for the next day’s price discovery simulation.
Given that you have determined your token’s opening price and the extent of its post-TGE pop, we can utilize these values to determine a starting price for the model, then simulate price discovery for a token’s first day of trading, then roll this price output to the continuous model to dynamically generate projected prices every day thereafter. By multiplying token price by your project’s Circulating Token Supply and Maximum Token Supply, we can predict key performance indicators such as Market Capitalization (“MC”), and Fully Diluted Valuation (“FDV”) which also become variables and influence liquidity. Based on these predictions, we can adjust and iterate various aspects of your Tokenomics to promote more desirable post-TGE performance.