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- This post has been written by HedgeTech
- This is Part 2 of the article. To read Part 1, please click on this link.
HedgeTech is an algorithmic crypto market maker for digital assets worldwide, with offices in Boston and Singapore. HedgeTech acts as designated market makers for token issuers and cryptocurrency exchanges. It also acts as technology providers for other market makers and broker-dealers.
Profits and Inventory Equilibrium Changes
Imbalance in inventory is one of institutions’ major concerns when they consider onboarding a DMM.
When the price goes sideways and oscillates, DMM make net profits — i.e. profits after deducting trading fees — from the difference in price between the maintained orders on the orderbook ladder. Indeed, a DMM would replace a filled maker sell order by a maker buy order at a price that is slightly higher than their best buy order and slightly lower than the maker sell order that was already filled. In doing so, DMM ensure systematic liquidity provision and spread narrowing, in order to make markets efficient. That said, should that newly placed maker buy order be filled at any point in time, the DMM will generate profits from the price difference between such a pair of orders: either base, quote or both will be in excess when compared to before the pair of transactions.
Figure 3. A market with fluctuations that offers profit opportunities for DMM.
When the price moves in a trend, one currency will be gradually exchanged for the other. For example, if the price of a base currency rises on the long run, it implies that the DMM’s maker sell orders are being filled along the way. As a result, base will be sold gradually for quote at a price in between the start price and end price of the trend. In other terms, no loss is realized but rather one currency is exchanged for another, sometimes temporarily if the trend reverses —then circling back with the fluctuations concept presented above.
Figure 4. A market showing an uptrend: overall some base currency has been exchanged for quote.
Risk Hedging Strategies
Some systematic liquidity provision strategies allow to further eliminate risk.
Orderbook replication — taking liquidity from one pair/one exchange to provide liquidity on another pair/exchange for the same base asset — is common practice among qualified DMM who want to fully hedge any type of risk associated with price movement. Indeed, DMM create profitable pairs of transactions instantaneously — rather then wait for the price to fluctuate — : whenever an order is filled on one side of the orderbook on the exchange where DMM provide liquidity, they immediately fill an order on the other side of the orderbook on the exchange from which liquidity is being taken from, taking into consideration trading fees and transfer fees between exchanges. Since they do so by making sure that the filling price of both orders is advantageous, they at least break even after fees or even realize profits.
Figure 5. HedgeTech’s HTClient app documentation explains the purpose and use cases of orderbook replication.
Although no losses are realized by DMM when the price moves, there still exists a risk of holding a given currency. For instance, if a client considers that holding BTC as a quote currency is a risk given that the USD value of BTC may go down while DMM operate, then DMM can explore hedging alternatives such as shorting BTC using BTC perpetuals for example. In the absence of a short position on BTC, the client would realize USD gains if BTC goes up but USD losses if BTC goes down. With a BTC short position opened however, if the price of BTC goes up, the short position would be losing but the BTC held would go up in value — and conversely — hence entirely hedging the risk of holding BTC to provide liquidity on a base/BTC market. The only drawback is that orderbook replication requires the existence of sufficiently liquid derivatives market for the assets being held. As a result, most base currencies tend to not offer hedging opportunities. However, if a DMM provides liquidity on major pairs on behalf of an exchange, then fully hedging the holding risk is possible.
Figure 6. Binance futures — one of the most prominent derivatives exchanges — only provides a limited number of perpetual contracts.
Price manipulators attempt to profit from fast “pump and dump” schemes. However, DMM design their strategies to be manipulation proof. Indeed, algorithms feature multiple mechanisms to prevent placing orders at a price that is not desired or to defeat rapid pump and dump attempts. Even if a market mainly exists through the DMM orders, manipulators will soon realize that they lose to the DMM orders on the long-run and even more so when the orderbook is composed of orders external to the DMM’s strategy.
DMM use multiple ways to protect their clients’ assets ranging from carefully calculating supply, to establishing trust via legal clauses, enforcing strict API permissions, answering clients’ questions on different price movement scenarios, hedging the holding risk of volatile currencies and even realizing profits whenever such opportunities are available.
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