In the last few months we have witnessed big changes on the bitcoin scene. The white-collar men took place of geeks and crypto anarchists wearing hoodies. Exchanges became a central point in the whole bitcoin hype. The race to be the first regulated and most secure marketplace is still ongoing, not only in the US. New bitcoin trading venues pop up like mushrooms, basically because bitcoin exchanges are currently one of the few business models which could be profitable in a relatively short time.
Most of the new exchanges focus on security and friendly UI. Once they are done with developing extraordinary features, they notice that something is wrong. Trading volume is poor, and so is their revenue from the trading commissions. They have missed a key factor of growth – the economic incentive to trade bitcoins. Fair price for both buyers and sellers for the requested volume is enough to satisfy all market participants. Then comes a “great” idea how to fix it. Shareholders and CEOs put down their own capital into their exchange and begin trading with their clients.
There are 3 reasons why this is far from perfect solution:
- Conflict of interest – bitcoin exchanges are centralised points of trade beyond of the blockchain. As a consequence they are not as transparent as the traders wish. Besides, security issues, there is the effect of asymmetric information between exchange owners and traders. Full knowledge about traders deposits, stop losses and take profits levels gives the exchange operator a huge market advantage. Following the example of professional ethics, exchanges can not trade with the traders. Otherwise, they should call themselves brokers. Presence of the independent market makers eliminates asymmetries. Market makers have the same knowledge about market as regular traders.
- Risk managment – If the exchange wants to animate market by themselves, they have to engage their own funds to trade with the counterparties. As long as bitcoin price is volatile the risk is high. Market makers use advanced tools, such as like derivatives and OTC contacts for hedging their exposure. In this case, it is reasonable to transfer the risk to the market maker.
- Performance – trading is a core of the business for the market makers. The more actively they trade, the higher their profits are. The bid-offer spreads are narrowed by offering constantly best prices to buy and sell bitcoins. Market maker could also put a large orders to encourage the institutional customers to trade on an exchange. Of course it does not work manually. Quantitative algorithms ensure that the market-maker maintains active in order book for almost 100% of time. The accidents with sudden price swings are reduced. The result is a classic win-win scenario between bitcoin exchanges, market makers and the all traders.
Professional market makers are just one of many elements that need to change before the bitcoin exchanges will acquire the institutional clients. Why bitcoin ecosystem need them? It’s a topice for the next article.