Market making in digital tokens used to be a font of outsized profitability. The picture today is very different as costs jump and investors avoid a crypto sector scarred by a $2 trillion rout.
The price crash led to bankruptcies like that of the FTX exchange, leaving a mountain of coins stranded on collapsed platforms and stoking fears of ongoing upheaval. Market makers have stepped up efforts to mitigate the risk of being ensnared by future turmoil, a shift they say erodes margins.
Liquidity providers Auros, GSR Markets Ltd. and Wintermute Trading Ltd. highlighted trends such as diversifying activity across more exchanges. They are also increasingly storing digital-asset inventories away from trading venues and using them as collateral to borrow tokens to deploy on crypto platforms.
Collateral is kept at custodians or prime brokers and only the tokens obtained from lenders are exposed if an exchange fails. For the market-making sector as a whole, using intermediaries contributes to a 20%-30% drop in profitability compared with depositing and leveraging up coins directly with a trading site, Auros said.
“The FTX debacle was a wake-up call for the industry,” said Le Shi, head of trading at Auros. Risks stemming from leaving assets on exchanges weren’t always prioritized “but that’s changed and we understand higher cost is going to be a way of doing business now,” he said.
Using dedicated, off-exchange custody providers can inhibit the scope to leverage, while providers of depository services also levy fees, Shi added. He stressed that the exact impact on margins varies greatly by company.
The business of enabling crypto trades and profiting from the difference between buying and selling prices showered cash on market makers in the stimulus-fueled, pandemic-era bull run of 2021. Wintermute that year had $1.5 trillion of trading volume, brought in $1.05 billion in revenue and achieved profit of $582 million with a staff of just 53, according to a report.
Crypto market value topped $3 trillion back then but has sunk to $1.1 trillion, hurt by higher interest rates that crushed speculative ardor. Market-making firms Jane Street Group and Jump Crypto have pulled back from digital assets amid low trading volumes and ebbing volatility, as well as a US regulatory squeeze on exchanges such as Binance Holdings Ltd. and Coinbase Global Inc.
‘Flight to Quality’
“Market makers are increasingly looking to reduce their exposure to centralized exchanges to reduce risks,” said Meng Hwee Neo, managing director of trading and Singapore co-head at GSR Markets.
The firm — historically active in trading smaller coins — is focusing more on the two biggest tokens Bitcoin and Ether in a “flight to quality” strategy, Neo said. “That comes at a cost to margins but they provide more volume and opportunities in this market condition,” he added.
The majority of trading in spot tokens occurs on centralized exchanges — marketplaces managed by companies such as Binance, Coinbase and OKX that take custody of assets to facilitate buying and selling. Crypto also offers peer-to-peer decentralized platforms like Uniswap that enable trading via algorithmic, blockchain-based software known as smart contracts, with users keeping custody of tokens rather than handing them over.
Monthly spot trading volumes at centralized exchanges slid 74% to $445 billion in August compared with January 2022, CCData show. Beyond spot tokens, market makers also operate in the larger digital-asset futures and options segment. Trading volumes for crypto derivatives have dropped too, roughly halving to $1.5 trillion over the same period.
Market depth, or the digital-asset market’s ability to shoulder relatively large orders without unduly impacting the price of an asset, illustrates the retreat of liquidity providers. The number of trades falling within 2% of the mid-price of Bitcoin on centralized exchanges is down more than 60% since October last year, research firm Kaiko wrote in a note in August.
“While this is partly due to structural reasons — market makers leaving the space after sustaining losses or permanently revising their risk management strategies after FTX — the low volatility environment is also playing a role in keeping liquidity providers out of the market,” Kaiko said.
Partial Rebound
Digital assets have partially rebounded in 2023 from last year’s steep selloff but remain well off their all-time highs. For example, Bitcoin is up 55% since the start of the year to $25,700, still more than $40,000 below its 2021 record.
Crypto companies are hopeful of further gains if pending applications for the first spot Bitcoin exchange-traded funds in the US get the green light. Some firms are turning to Asia for a growth revival, arguing clearer regulations there will help spur regional crypto demand. Wintermute co-founder Yoann Turpin said in July that he planned to move to Singapore along with some of his staff.
What the liquidity providers all need is for investors to come back to digital assets. “Without the influx of new sources of flow into crypto it will be difficult to expect a new crypto summer anytime soon,” said Neo of GSR Markets.
