The Importance of Market Making in DeFi

Market making is the ability to price assets in a way that maximizes liquidity. This is a skill that unsophisticated parties often lack in traditional financial markets, but it’s an essential aspect of any DeFi protocol.

Automated market makers (AMMs) are a staple of the decentralized finance (DeFi) ecosystem, and have grown into an important part of its infrastructure. They’re a form of a decentralized exchange that uses smart contracts to create and manage markets.

AMMs are a key component of any DeFi Market Making protocol, and play a critical role in ensuring liquidity on the exchange. AMMs do this by interacting with a smart contract to price tokens in the exchange’s trading pool.

They also earn a commission for providing liquidity. This incentive structure has helped to drive users to many DEXes, and has fueled the rapid growth of many DEXes in their early days.

There are a number of reasons why MMs are important in the DeFi space. First, they provide liquidity by allowing traders to trade between multiple tokens at once. This means that more people can participate in the market, and the price of a token can rise or fall faster.

Second, MMs can provide arbitrage opportunities, which allows traders to buy and sell the same token on different exchanges at a lower cost than if they were to purchase them on one particular exchange. Historically, this service has been difficult to provide in the traditional financial markets because there isn’t enough liquidity for it to be effective.

Third, MMs can also ramp up the market by creating the impression that they’re a big buyer or seller of a specific asset, which can increase FOMO and trigger trading by others who rush to be the next “big buyer.” They can also leverage their predictive skills to create ghost buyers who trade in large amounts at irregular intervals, increasing the price of a token temporarily before disappearing as the market catches up with them.

The ability to ramp up the market can be extremely profitable for a MM, and it’s often one of the most lucrative ways to make money on an exchange. However, it’s important to keep in mind that MMs can lose money as well.

Typically, a MM is going to need to predict with sufficient accuracy the spreads on a given asset pair to be able to profitably ramp up. For example, if Bob appears and pays 2001 USDC for 1 ETH, the MM will need to know that the spread will outweigh Bob’s inventory risk and execution costs so they can profitably ramp up and earn a reasonable margin.

If the spread is not sufficient to outweigh Bob’s inventory risk and execute costs, then a MM will have to sell some of its inventory at a loss in order to stay viable. This is a risk that MMs don’t like to take in the traditional financial markets, but it’s necessary to keep them operating.

Another risk that MMs face is liquidation risk, which occurs when an abnormal price movement makes the underlying token unavailable to be traded. This is a unique risk that DeFi protocols must address, and they do so by offering liquidity pools. These pools are created by users who deposit tokens into a DeFi protocol’s smart contract, and thereby ensure liquidity on the exchange.