For markets to function, they need to have enough assets for all users to buy and sell. If you want to sell ‘x’ and buy ‘y’, there needs to be some ‘y’ in the market for you to purchase. Market makers are intermediaries that make this possible by providing market liquidity to facilitate the exchange of assets.

Market makers offer to buy and sell assets at specified prices, resulting in a "bid" and "ask" spread. In a trade, the bid is the highest price someone will pay for an asset while the ask is the lowest price at which someone will sell an asset. The market maker keeps track of all offers in its orderbook, helping buyers and sellers execute trades, while charging trading fees and profiting from the price spread.

In traditional financial markets, Robinhood and Webull are examples of popular market makers for retail stock traders. In crypto, market makers are also known as exchanges. Coinbase, Binance and Gemini are a few of the biggest centralized exchanges in the cryptocurrency space.

How Market Makers Work

Market makers enable market functionality by providing their own liquidity, allowing users to effectively trade predefined asset pairs. They maintain constant buy and sell quotes, ensuring that trades are executed quickly. This helps to reduce price volatility and support price discovery.

Market makers profit from the spread, which is the difference between buying and selling prices, and may charge a fee for each trade they execute. Their involvement lowers trade delays, which contributes greatly to overall market stability.

Here’s how the process looks from the users’ side:

A user creates an account, then deposits the asset they want to trade.
User looks through available market pairs and creates a buy or sell order on the order book for the desired market pair.
1. The order book is a list of all the open buy and sell orders waiting to be fulfilled. If the exchange does not have enough buying and selling volume, this can cause the order book to have significant spread. Spread is the difference between the highest buy order price and the lowest sell order price
If a buy order has the same requested price as a waiting sell order, the market maker will execute the trade and take a small portion of the traded assets as a fee.

Automated Market Makers

Automated market makers (AMMs) are a type of decentralized exchange system that enables cryptocurrency trading without using a traditional order book. They are an essential innovation from the cryptocurrency and DeFi space. Examples of AMMs are Uniswap, 1inch, PancakeSwap and Paraswap but there are many more depending on the blockchain you are using.

The big difference between traditional market makers and automated market makers is that AMMs leverage smart contracts to calculate asset prices autonomously, using algorithms and liquidity pools funded by users. Rather than matching buy and sell orders, AMMs allow trading against the liquidity within these pools, with prices adjusted according to asset ratios.

Liquidity pools are collections of tokens locked in smart contracts. They ensure there’s always liquidity, allowing decentralized trading to occur seamlessly and continuously. Liquidity providers contribute their tokens to these pools and, in return, earn incentives like transaction fees or governance tokens. This system minimizes price volatility (slippage) and enhances market accessibility, allowing anyone to participate. Overall, liquidity pools are vital for efficient and decentralized trading within AMMs.

AMM’s Role in Crypto

Crypto market makers, or exchanges, have been around since the very early days of crypto. The first one, called Bitcoin Market, launched in 2010. Another market maker called Local Bitcoins was a peer-to-peer exchange.

Already, these were different from the traditional market makers. Users would sell Bitcoin to each other, specifying how much they were willing to sell/buy and for what price, while the exchange would act as a custodian or escrow holder. While in traditional finance market makers only allow you to transact during the hours where the market is open, these crypto markets were open 24/7.

The creation of blockchain smart contracts on Ethereum opened the doors to even more innovative possibilities with crypto trading. Now, you could have markets that weren’t just always open, but didn’t need to rely on a centralized entity and could allow users to stay in control of their assets the entire time.

The first ever AMM created on the Ethereum blockchain was Bancor which was introduced in 2016 as a concept, then launched the following year, laying the groundwork for future decentralized exchanges. Uniswap is currently the most popular AMM and was the second one ever created. Uniswap launched in 2018, then would go on to achieve significant trading volume and spark the AMM wave in the DeFi space. Curve was launched in 2019 and was specifically designed for efficient trading of stablecoins and other similarly priced assets.

AMMs are vital in the crypto ecosystem as they provide the means to trade one token for another even across different blockchain networks without relying on a centralized entity. If you wanted to swap to a token that was unavailable on a centralized exchange or preferred to retain control of your assets throughout the process, you could use an AMM to swap to that token instead.

Thanks to advancements in AMM technology and algorithms, users can supply liquidity in multi-token liquidity pools and even use routes that will use multiple liquidity pools to get you the best trade. These algorithms help with spreading liquidity and stabilizing the price of the assets, but also allow any user to become a reward-earning participant in the market making process.

If you want to learn more about liquidity pools, this article goes more in depth on how they work and their role in DeFi.

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