What is liquidity?
Liquidity in financial markets refers to the "saturation" of the market with money through orders and positions. This allows traders to swiftly sell shares (or currencies) in large quantities. The greater the market liquidity, the easier it is to buy or sell an asset in substantial amounts without incurring significant losses due to slippage.
Slippage
is the primary challenge for large players. Major funds often find it difficult to manage large positions, frequently closing transactions at a loss because of order "slippage."
Order slippage happens when a transaction is opened at one price but executed at another, differing from the expected price. When a trader handles a few hundred dollars, liquidity issues are rare (except in the case of highly illiquid third-rate cryptocurrencies).
However, managing hundreds of millions of dollars makes it challenging to open and close positions simultaneously, which is directly tied to market liquidity.
Market liquidity is maintained by market makers, whose primary role is to ensure liquidity. These participants strive to make trading as seamless as possible, preventing sharp gaps in quotes and ensuring that both buyers and sellers receive favorable prices.
In a market without market makers, we frequently observe sharp price swings, significant asset fluctuations, and gaps in quotes.
How does a market maker work, and why is he not a puppet master?
Many traders believe that the market maker is a puppet master manipulating prices, triggering stop levels, and deceiving the crowd into stop orders However, this is a misconception.
A market maker does not need to orchestrate losses for the crowd Traders often incur losses on their own due to spreads, commissions, and swaps The market maker’s role is not to shift market prices in any particular direction.
Under their agreement with the exchange, a market maker's responsibility is to provide a buy quote to buyers and a sell quote to sellers, as well as to fill the empty "market depth" when necessary.
Without market makers, the market would be vastly different We would frequently witness price gaps, quote gaps, and constant squeezes in both directions, along with significant price jumps These phenomena are still observable in markets where it is not profitable for market makers to operate, such as many US penny stocks.
New AMM Technologies in the Crypto Market
What if we replace a participant with a smart contract? In other words, what if, instead of market makers, we implement an automatic system to adjust supply and demand, as well as manage general quotations?
This concept is the foundation of decentralized exchanges (DEXs), which were the first to use the Automated Market Making (AMM) mechanism.
The AMM algorithm operates through a special liquidity pool, utilizing the resources of participants to facilitate transactions between them The algorithm controls the price and volume of exchanges, theoretically allowing all sellers and buyers to trade without incurring losses In practice, however, all DEXs experience significant price slippage Large transaction volumes can result in substantial losses during token exchanges.
Furthermore, this innovation has not eradicated market manipulations DEXs are still vulnerable to various forms of manipulation For instance, token creators can easily pump their tokens and deplete the entire token liquidity pool.
How Do Market Makers Combat Price Manipulations?
While it is not their primary responsibility, market makers often prevent pump-and-dump schemes from taking off.
When prices are artificially driven up by fraudulent participants, market makers can intervene early They do this by placing large limit orders against the manipulator, thereby quelling the rising demand This tactic often disrupts the pump scheme, causing new participants to falter However, if the pump is meticulously planned and executed with a significant influx of market orders, it can temporarily force the market maker to withdraw from the market.
When Do Market Makers Leave the Market?
Most market makers have clauses in their agreements with exchanges allowing them to turn off their algorithms and exit the market during holidays, periods of abnormal activity, and times of significant news releases.
This precaution is taken to protect their capital.
We can immediately recognize the absence of market makers by the extended spread Have you noticed how the spread widens significantly, even on ECN platforms, during major global news releases? The typically narrow spreads are maintained through the efforts of market makers Without their presence, we would encounter extremely unfavorable trading conditions, including wide spreads, significant price slippages, sudden dips, and price spikes all the unpredictable fluctuations that characterize a volatile market.
What is a Market Maker's Inventory Risk?
Contrary to popular belief, market makers do bear significant risks, the foremost being inventory risk.
Inventory risk occurs when a market maker's position shifts sharply in one direction, preventing them from off-loading it profitably through the spread For instance, if a panicked crowd sells an asset en masse, the market maker must buy the entire supply, potentially driving the price down and leading to losses.
Market makers mitigate this risk using spread-centering equations and determining optimal buying and selling prices. However, this is not always feasible Even when prices are not optimal, market makers must continue supplying liquidity, sometimes operating at a temporary loss to fulfill their role.
Analyzing the Largest Market Maker on the planet - Kenneth Griffin's company
Examining the largest market maker globally, Griffin's company, founded by Kenneth Griffin, highlights its crucial role in financial markets Griffin's company' reports reveal a substantial impact it provides liquidity for 7 out of 10 trades in the US stock market, showcasing its importance in maintaining market stability and liquidity.
The scale of Griffin's company' influence is evident, with about 900 million shares of US stocks traded through its algorithms daily This volume underscores the company's active and significant presence in the US exchange.
Kenneth Griffin's journey from directed trading to market making is noteworthy Griffin's company is also expanding into global markets, actively engaging with Asian exchanges to provide liquidity, illustrating its growing international footprint.