Trading and Investing

What Are Market Makers & Maker Fees?

Published
August 22, 2022
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    The New York Stock Exchange began as an open-air market where traders met daily to buy and sell stocks and bonds. With the rise of electronic trading, most trading moved from in-person to online, where algorithms could match buyers and sellers more efficiently. And today, most traders and investors simply click a button from behind a screen.

    Unfortunately, technology has a habit of masquerading how things work under the surface. Most traders and investors don't understand what happens after they click a button. However, the crypto ecosystem is rapidly democratizing exchanges, enabling anyone to participate in corners of the market typically reserved for institutions.

    Let's take a closer look at how exchanges work and how crypto traders and investors can become market makers.

    The crypto ecosystem is democratizing financial services, including exchanges where anyone can become a market maker.

    How Exchanges Work

    Most traders and investors use exchanges to buy and sell stocks, cryptocurrencies, and other assets. Rather than manually finding a counterparty, exchanges match buyers with sellers in a centralized marketplace. In other words, they provide liquidity to a market by ensuring that anyone can buy or sell at any time.

    Centralized exchanges (CEXs) use an order book to aggregate offers to buy or sell and calculate the market value of an asset. For example, the Coinbase order book for Bitcoin (below) shows asks at $22,995.00 and bids at $22,992.52. The median of $22,993.76 represents the market price, while the spread (e.g., bid/ask difference) stands at $2.48.

    Crypto Market Maker
    Coinbase Pro Order Book for BTC/USD. Source: Coinbase

    While CEXs remain the most popular way to trade, decentralized exchanges (DEXs) use automated market makers to sidestep the need for order books. Instead, DEXs use algorithms and liquidity pools to set prices based on supply and demand. As a result, trades are immediately executed without waiting for a counterparty or limit order.

    The latest crypto exchanges combine different protocols and mechanisms to increase liquidity across platforms. For instance, the 1inch Exchange aggregates liquidity from different DEXs to minimize slippage on large orders. That way, a large buyer can place an order without worrying about an individual platform's liquidity.

    What Are Market Makers?

    The two most common order types are limit orders and market orders. Market orders execute automatically at the current ask price and process immediately. However, limit orders specify a price and may remain in an order book for a long time. As a result, many limit orders add liquidity to a market at different price levels.

    Traders or investors that place a limit order are known as market makers since they add liquidity to a market. On the other hand, those that place market orders or limit orders close to the market price are known as market takers since they remove liquidity from a market. Sometimes, limit orders must be marked as "post only" to be a maker.

    On DEXs, market makers are known as liquidity providers (LPs). Rather than adding limit orders to fill out an order book, LPs contribute tokens to a liquidity pool that works with an algorithm to make a market. Anyone that places a trade through a DEX is a market taker since they're removing liquidity and decreasing the size of the liquidity pool.

    For example, Uniswap users pool their tokens together to create a fund that executes trades on the platform for a flat 0.3% fee. These fees are split among everyone in a given liquidity pool based on their contribution percentage. If a token is in low supply, a single LP constitutes a large percentage of the pool and earns more fees – incentivizing liquidity.

    Some of the top institutional market makers in crypto include:

    • GSR Markets
    • Kairon Labs
    • Alpha Theta
    • Almeda Research
    • Bluesky Capital

    What Are Maker Fees?

    Historically, market makers have been large institutions or specialists that maintain their own order books. So, for example, when there's a market order to buy 100 shares, they will purchase the stock from a seller in their order book at the bid and sell it to the buyer at the ask. As a result, they profit from the spread between the bid and ask prices.

    With the rise of electronic trading, many exchanges have moved to a maker-taker system. For example, an exchange might offer makers a $0.002 per share rebate and charge takers a $0.003 per share fee. The goal is to incentivize traders in markets with tight bid/ask spreads since there's less profit potential for traditional market makers.

    DEXs incentivize liquidity providers a little differently since they don't typically use centralized order books. So rather than providing a rebate or discount on a trade, DEXs reward traders and investors for contributing to a liquidity pool using fees generated from facilitating transactions. And the level of reward depends on the liquidity requirements for the tokens.

    Of course, there are some DEXs that are blurring the line. For example, Serum is a highly performant and scalable DEX built on the Solana network that utilizes a central limit order book (CLOB) rather than an automated market maker to power its trading infrastructure.

    While traders and investors can act as market makers to reduce their fees or earn income, they give up the ability to execute trades quickly. This is because market-making limit orders must be sufficiently far away from the market price to contribute liquidity, meaning that they will not execute until the market price moves far enough to trigger the trade.

    The Bottom Line

    Market makers are traders or investors who add liquidity to an exchange. As an incentive, they typically pay a lower commission (maker fee) than market takers that pay a taker fee. And on DEXs, they usually receive rewards in exchange for providing liquidity. But, the trade-off is that these trades don't execute immediately at the market price.

    Stock exchanges continue to evolve with the advent of high-frequency trading and payment for order flow (e.g., Robinhood's questionable business model). However, crypto exchanges have taken a much more democratic approach by enabling anyone to contribute liquidity in exchange for discounts or rewards – a win-win for everyone.

    If you trade cryptocurrencies, ZenLedger can help you keep everything organized for tax time. Our platform automatically aggregates transactions across exchanges, computes capital gains or losses, and populates the IRS forms you need to file each year.

    Sign up and get started for free today!

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