Fundamentals: Types of Market Makers

Before We Begin

We recommend revisiting our past two blog posts in our Fundamentals series ahead of reading this article. You can find those articles here:

Fundamentals: Basics of Market Making
Fundamentals: Liquidity and Price Discovery

Fundamentals: Types of Market Makers

Cryptocurrencies have catalyzed a revolution in finance, championing decentralization. Market makers act as pillars supporting this evolution. In this guide, we will share the three prevalent market making structures: Principal Market Making, Designated Market Making, and Self Service Market Making. 

Principal Market Making (PMM):

Targeted at top tier projects, Principal Market Making is rooted in the conventional loan call option model. It caters to those seeking abundant, diverse liquidity. We would recommend Principal Market Makers who offer some level of transparency. This can be in the form of recurring reporting or even better as a live dashboard. 

Features:

• Loan-Call Option Model: the structure of this agreement is typically based on a token loan and an associated American call option. The issuer and market maker will decide on loan amount, strike prices, term length, interest rate, and other key details.

• Discretionary Liquidity Provision: the market maker assumes the onus of deciding liquidity levels, considering both the breadth of market presence and critical trading ranges.

Positives:

• Lowered Risk: by merely loaning out the tokens they issued, issuers mitigate capital risk on the downside.

• Flexibility: liquidity levels are determined at the market maker's discretion, allowing adaptability. 

Negatives:

• Potential Opacity:  while certain liquidity metrics may be trackable, the overall strategy is at the discretion of the market maker.

• Seller’s remorse: as a counterpart to the lower downside risk, issuers forfeit their exposure to the upside. Indeed, as they only loan the token they issued, they might miss out on potential gains, given the call option associated with the loan.

• Trading Expertise Required: to appropriately engage in a PMM contract, an issuer must have some level of trading knowledge to ensure that the deal is fair and misunderstood subtleties such as uptime can make a huge difference.
  

Designated (Managed) Market Making (DMM):

This approach works on a retainer plus performance fee mechanism. Issuers contribute both base (the token they issued) and quote (typically stablecoin) capital, eyeing consistent liquidity across selected exchanges.

Features:

• Retainer Model: designated or managed market making utilizes a retainer plus performance fee payment structure to ensure adequate liquidity

• Integrated Strategy: it incorporates established strategies, top tier modeling, and monitoring to optimize capital allocations and ensure efficient price discovery.

• Transparency: every step, from strategizing and execution to reporting, remains open to the issuer.

Positives:

• Precision: tailor-made for entities desiring assured liquidity on target exchanges.

• Full Control: direct capital provision by issuers grants them significant control.

• Upside: if the token is widely adopted, the issuer directly benefits through the upside exposure.

Negatives:

• Increased Cost: compared to PMM, this model requires monthly service fees.

• Risk: given the exposition to the upside, issuers are facing a risk on the downside.

  
  

Self Service Market Making (SSMM):

SSMM bestows projects with the freedom to establish their corporate accounts, fund them, and set their desired parameters. Non-custodial technology platforms facilitate this autonomy, allowing issuers to provision liquidity or manage assets directly.

Features:

• Autonomy: issuers remain firmly in control, steering account setup, funding, and configurations.

• Customization: monitoring and reporting tools empower issuers to tweak strategies and monitor outcomes in real time.

Positives:

• Scalable: a strong SSMM offering allows for unparalleled scalability across exchanges, chains, and strategies.

• Cost Effective: issuers can save and allocate resources internally as opposed to spending more to hire external third parties.

• Direct Oversight: direct asset monitoring ensures immediate interventions if necessary.

Negatives:

• Trading Expertise Required: without prior knowledge, issuers might find it challenging to optimize strategies.

• Time Consuming: demands regular monitoring and adjustments, potentially diverting resources from other tasks.
  

Market Maker Summary:

Choosing a Market Maker:

1. Set Realistic Expectations: grasp what market makers can realistically achieve. They are vital, but your project's value and delivery play an equal role.

2. Understand Contract Models: ascertain which model aligns with your immediate needs without sidelining long-term aspirations.

3. Consider Diversification: depending on the token economic model and the size of the project, more than one market maker may be a viable option to diversify the type of service and liquidity provided. 

4. Price & Performance: higher costs do not guarantee enhanced performance. Often, smaller teams might deliver more personalized attention.

5. Beware of Red Flags: market makers appearing too promising or engaging in dubious practices warrant caution.

6. Transparency is Vital: opt for market makers advocating clear reporting and open dialogue, ensuring alignment in objectives.

Conclusion

The right market-making structure is quintessential for your project's liquidity and longevity. With an understanding of each model's pros and cons, projects can make enlightened decisions, ensuring a robust presence through market cycles.