Why Embedding Algorithmic Market Makers Into Matching Engines Can Jump-Start Liquidity

The cryptocurrency space is witnessing a resurgence to all-time highs, with the price of Bitcoin reaching a high of $73,000 as of March 2024.

Similarly, the decentralized finance (DeFi) market has reawakened from its slump, reaching a year-high TVL of $103 billion at the tail end of February this year. Forecasts show the crypto market is set to grow even larger in the coming years – revenue across the field is expected to reach $71 billion by 2028, representing an 8.26% CAGR over the period. 

The Importance of Market Makers in the Cryptosphere

Market makers have (and will continue) to play a crucial role in the growth of the space. They help traders and crypto holders manage liquidity across exchanges and platforms by buying and selling digital assets, to ensure the space remains highly liquid at all times. In addition, crypto market-making facilitates price discovery, ensuring purchases are made at a fair price, and removing arbitrage opportunities in the market. Finally, market makers also help mitigate risks and tighten spreads between prices, making the wildly volatile markets stable and attractive to trade. 

All these benefits help to enhance market efficiency and allow markets to grow as a whole. Their abilities to provide stable market prices and narrow bid-ask spreads also help create a more robust and resilient crypto market – traders, buyers, and sellers can execute transactions more efficiently while buying and selling their assets at the best prices possible. 

Crypto market makers select different strategies to complete their job. It is in no way a one-fits-all strategy. Nonetheless, market makers choose their preferred strategy depending on a number of factors, including trading skills, expertise, risk appetite and volume of liquidity. One of the fastest-growing strategies, algorithmic market makers (Algo MMs), is making their mark in the space due to their efficiency and ease of use. 

In this article, we delve deeper into how algorithmic market makers are revolutionizing matching engines and jump-starting liquidity. The article will further discuss the key advantages they offer, the difficulties Algo MMs face, and what the future holds for this innovation. 

What is Algorithmic Market Making? 

Algorithmic Market Making, as the name suggests, means using algorithms to help traders manage liquidity, by buying and selling digital assets. This strategy is becoming a popular approach for many market makers, given the ease and efficiency it offers when creating liquidity in the market. 

As Dimitrios Kawathas, Chief Strategy Officer at Ithaca, a non-custodial platform offering options trading, Algo MMs and collateral optimization, explains: 

“ Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of computers relative to human traders.” 

The Advantages of Algorithmic Market-Making 

While the crypto markets are used with Automated Market Makers, or popular as AMMs, algorithmic market makers (Algo MMs) offer more advantages than their predecessors. 

  1. Increased trading activity: Algo MMs allow market makers to trade with speed and accuracy, which means they can execute huge volumes of trade in fractions of seconds. This ensures constant liquidity and increased activity in the market. 
  2. Minimize risk exposure: By using Algo MMs, market makers are able to ensure they hold the correct amount of inventory at all times. This can help minimize the risk of having too little inventory when the market requires liquidity or too much liquidity when a market drawdown happens. 
  3. Faster execution of trades: Another advantage of Algo MMs is facilitating lightning-speed trading, reducing the time between order placement and execution. This is important as market makers need to be able to respond quickly to changes in the market, especially given the volatility in the crypto market. 
  4. Efficient market making: One of the biggest advantages Algo MMs offer market makers is improving their trading activities. As market makers continuously quote bid and ask prices, Algo MMs can help adjust quotes in relation to the market conditions, supply and demand to make them as profitable as possible. 
  5.  Arbitrage opportunities: Algo MMs quickly identify price discrepancies between different markets or assets and exploit them through arbitrage strategies. This aligns the market prices fast, ensuring market efficiency. 

Despite the advantages, algorithmic market-making faces a couple of challenges, which have hindered the adoption of the technology or widespread integration within the DeFi space. Let’s take a look at some of the drawbacks and challenges Algo MMs face. 

Challenges to Incorporating Algorithmic Market Makers in DeFi

Algorithmic market making is still at its nascent stage and as such the technology is expected to face several pitfalls. First, to make Algo MMs effective, traders need to have access to high-quality market data from many trading platforms that can handle large trading volumes. 

Additionally, market makers are required to have a deep understanding of market dynamics. These platforms require market makers to understand their trading strategies to minimize risk and effectively provide liquidity – to maximize their profits. 

Notwithstanding, algorithmic market making may face regulatory restrictions which makes them less effective in the DeFi ecosystem. Given that these automated trading systems are designed to follow a set of predetermined rules, Algo MMs in jurisdictions with strict financial regulations in DeFi could cause the platforms to be less effective and may not be able to easily adjust to changing market conditions. Luckily, platforms such as Ithaca employ a regulatory-compliant structure that allows users to easily change the set of rules to minimize losses and maximize profits. 

The algorithmic market makers also involve creating sets of rules based on several factors such as moving averages, market dynamics, supply, demand and other technical factors. Integrating these into a market maker’s trading strategy could be challenging. However, platforms such as Ithaca enable users to easily set up (or program) their preferred strategies into their Algo MMs, ensuring trades are executed automatically and efficiently, despite the market conditions. 

The Technological Future of Algorithmic Market Makers 

Algorithmic market makers are revolutionizing how liquidity is provided and risk mitigated across the crypto space, enabling faster and more efficient trading. However, with this burgeoning crypto market and advancement in technology,  it is essential for market participants to stay ahead of the curve and anticipate future trends and innovations in this field. 

One of the biggest and most exciting technological advancements is artificial intelligence and machine learning. By leveraging these technologies, Algo MMs will be able to analyze vast volumes of trading data and identify patterns, hence enhancing market making. In addition, AI could help market makers optimize their trading strategies and make more accurate predictions on future market dynamics, helping them adapt to the ever-evolving world of crypto in real-time. 

Finally, the Algo MM space could see an introduction of predictive analytics and sentiment analysis, helping market makers gain valuable insights into the volatile crypto market dynamics. From analyzing real-time news to social media trends and other data sources, market makers can build algorithms that gauge the market sentiment and adapt accordingly in real-time. 

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