Crypto Market Making: How to Weed Out Parasitic Operators

TLDR: 

• Many people view new digital assets as pump-and-dump schemes due to the prevalent parabolic rise and immediate collapse of tokens during initial trading

• Market makers play a critical role in either promoting or inhibiting fair price discovery in primary listings

• Leveraging objective evidence for 93 primary listings on major exchange from year-to-date, we discovered that a staggering 78.5% were conducted by market makers in a disorderly and parasitic manner that inhibited fair price discovery, hurting end-users and projects

• The Relative Change in Volatility, or RCV, can be utilized to gauge the impact of pre-market order book strategies on price volatility and holds market makers accountable to a higher standard for their critical roles in enabling efficient price discovery.

• This opinion and research have been covered in the following article on Cointelegraph.

Crypto Market Making: How to Weed Out Parasitic Operators

Is every crypto a pump-and-dump scheme? Many people rightfully ask this question because one common theme users notice with nearly every new listing is a massive rise to unsustainable prices, followed by the cliche collapse, leaving participants holding the bag. Thus, the question becomes, who is behind the curtain allowing this theme to propagate? We would argue that market makers not only play a significant role in enabling the rapid boom and bust cycles that most new listings undergo within their first 24 hours of price discovery but are a remedy for this exact phenomenon. 

Let us first explain the context of primary listings in crypto as well as the role of market makers. Then we will look at the objective evidence demonstrating an orderly primary listing compared with the familiar inverted-V pattern of disorderly launches. 

The transition from private to public market trading via primary listings for digital assets is analogous to an IPO’s in traditional securities markets, with one significant structural difference: the opening price for a digital asset market is often purposefully underpriced by digital asset issuers, leading to much higher first-day performance than in traditional markets.

In traditional markets, passive investors mainly hold shares, whereas, in digital asset markets, tokens are ideally held by active network participants. As such, the long-term success of a digital asset market is highly dependent on the strength of its token holders. The offer price of securities is determined by the investment bank that underwrites the IPO and purchases the shares from the issuer at a discount prior to them being sold in the open market. For tokens, there is no investment bank underwriting the listing and the price discovery is entirely determined by the open market. Instead of underwriting an offer price, the price of the public round is often the most justifiable listing price for a token. However, this price is far below the fair market price in practice. The result is frequently much higher first-day pops in digital markets compared to traditional IPOs. However, the same market-health heuristics apply: pops are higher in bull markets and lower in bear markets.

Now that we understand the context in which digital assets are structured for their initial listing, we can examine the role of a market maker. 

Structurally a market maker, during a primary listing, has access to a large percentage of the circulating supply of an asset and is tasked with seeding the initial liquidity for the market on both centralized and decentralized exchanges to enable users to trade. The way this liquidity is seeded is through an exchange’s pre-market order book. Essentially, exchanges open the market to market makers first, so that market makers can place liquidity in the order books ahead of the market opening to the public. The objective is to ensure that sufficient liquidity is available to the public once the market begins trading. Thus, it is imperative that market makers construct the amount of liquidity provided through pre-market order books in a symbiotic way, with the objective of allowing the asset to go through efficient price discovery. 

With that being said, some market makers purposefully undercapitalize the order books for the primary listing to inflate their short-term profits at the expense of the token community and the project itself.  This practice falls under the “parasitic” market-making approach that we expand on below.  

Let's walk through the different approaches for supplying liquidity for a primary listing via pre-market order construction:

1. Parasitic Approach: This approach involves a market maker who capitalizes on premarket conditions by staying inactive initially, allowing uninformed retail bids to increase to unnaturally high prices, and manipulating market sentiments by creating artificial scarcity and demand ("FOMO"). At the optimal moment, the parasitic market maker shorts the token aggressively, placing high sell orders to absorb demand, causing a perpetual decline in the token's price. This strategy is harmful to the token market as it feeds off the initial demand, resulting in detrimental, and oftentimes irreversible, effects.

2. Transitory Approach: Similar to the parasitic approach, the market maker in this strategy games the premarket order book and uses their dominant position to place overwhelming sell orders to ensure their positions are filled. Typically adopted by market makers seeking to quickly maximize fees or close OTC trades, this approach leads to a rapid exit from the market, removing any potential price upside by heavily selling off the token.

3. Symbiotic Approach: In contrast to the other two, this approach involves a market maker who uses their understanding of the premarket order book to strategically set up the opening liquidity, aiming to build long-term value. This results in a price discovery phase that accurately reflects the asset’s true market value. The market maker supports this by providing liquidity on both sides, facilitating an orderly price discovery process.

Now that we understand the role that market makers play, their significant ownership of the initial supply of a token, and the approaches market makers take to structuring the initial liquidity for the primary listing, we must objectively quantify the three approaches to understand how prevalent parasitic approaches are in the market for primary listings of digital assets. 

To assess the efficacy and approach of market makers' strategies, we delve into a detailed analysis. We track the price multiple performances of tokens within two critical periods: the initial two days post-listing (analyzed hourly) and the first two weeks (analyzed daily). This data, sourced from the project's primary trading platform or reliable aggregators, undergoes normalization for comparative analysis across different projects.

Central to our analysis is the Relative Change in Volatility, or RCV, to gauge the impact of pre-market order book strategies on price volatility. It's calculated by the following formula. 

This output quantifies the change in volatility when the ATH (All-Time High) price is considered versus when it's excluded. A higher absolute value of the RCV indicates a more significant discrepancy in volatility, pointing towards potential mismanagement of the pre-market orderbook.

• A positive value suggests an undersupplied order book, potentially indicative of a parasitic or naive market maker who fails to provide adequate liquidity pre-market.

• A negative value implies an oversupplied order book, which might be characteristic of an overly aggressive transitory market maker or an asset priced too high.

• A neutral value, implies a symbiotic order book, characterized by sufficient, but not excess liquidity provided to enable orderly price discovery of the asset 

We previously applied a case-study, introducing the RCV methodology, but how does that apply over the broader context of primary listings in general? 

To arrive at a definitive conclusion about the state of primary listings and the approaches market makers take, we apply the RCV methodology across 93 primary listings (pulled from our recent exchange listing performance research) which took place from April 2024 year-to-date on Bybit, Kucoin, Binance, Coinbase, Kraken, OKX with the results shown in the chart below:

As shown in the graph above, 69.9% of all launches were categorized as Parasitic, while 8.6% were Transitory, leaving only 21.5% of launches with a symbiotic approach. This means that a staggering 78.5% of primary listings were conducted in a disorderly manner that inhibited fair price discovery, hurting end-users and the project.  

In fact, we noted that for Parasitic launches, the market is 420% more volatile when including the all-time high point, signaling a considerably undersupplied market. This exposes traders to entry at hyper-inflated prices leading to market abandonment. For Transitory, the market is 34% less volatile when including the all-time high point, signaling an oversaturated order book where initial supply was mismanaged. This leads to a scenario where the market maker alone capitalizes on the initial flow rather than the community. In both the parasitic and transitory approaches, the market’s price discovery is greatly harmed reducing the likelihood of long-term market engagement while symbiotic approaches yielded an RCV of +/- 20%, providing a fair, healthy foundation for price discovery to occur.

As the digital asset industry continues to grow in both legitimacy and size, it is imperative that market makers remediate the overwhelming mismanagement of primary listings. We encourage digital asset issuers and exchanges which are engaging market makers to leverage the RCV methodology to analyze whether the market maker appropriately structured the initial order book. 

The image of market makers is terrible, and as the data shows, with good reason. It’s time to set the bar higher, weed out parasitic operators, and hold market makers accountable for their critical role in enabling efficient price discovery. Our industry deserves it.