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MCS | Risk Management in Designated Market Making [1/2]

15 days ago

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- This post has been written by HedgeTech

*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.


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For simplicity reasons, this article will use the example of spot markets where a base currency is traded against a quote currency.

Inventory Calculation and Engaged Inventory

The base and quote currencies inventory that the client should provide for market making is calculated according to a number of factors. First, a DMM would take into consideration the fundamentals that are the base currency latest price — whether private sale price, public sale price or market price —, the currency circulating supply as well as factors influencing it — minting/burning, vetting, stacking — and total supply if set in advance. Second, the exchanges on which the asset will be traded and the quote currencies that the asset is traded against coming into play in this calculation. Third, the objectives of the client — and sometimes the requirements of the exchanges — in terms of price spread, the density of orders, and average amount per price level play a significant role in the inventory calculation. Last but not least, DMM makes sure to ask for sufficient yet not excessive inventory — due to the risk inherent to holding assets on an exchange’s account — to be able to cover a wide price range without having the client refill the accounts in either base or quote currencies.

Given the aforementioned, given API limits of most exchanges — that only allow users to retrieve a given maximum number of orders — and for risk management purposes, DMM would not engage the entirety of the inventory initially provided. Rather, they would use a fraction of it to maintain liquidity around market price at all times, dynamically replacing orders filled by new ones using algorithms.

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Figure 1. HedgeTech’s HTClient app offers full control over strategies along with monitoring features. Here, a monitor display showing available balances / total balances (names have been blurred for confidentiality reasons).

Permissions and Legally Binding Contracts

DMM usually connect their algorithms directly to clients’ accounts via the accounts’ API keys. A significant number of exchanges allow account holders to manage API key permissions. In other words, DMM’s clients can grant and/or deny access to the DMM for certain functions. Reputable DMM would always ask their clients to deactivate withdrawal permissions, as this serves as a simple yet efficient way of managing potential bad intentions.

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Figure 2. API keys creation page on Bitfinex, showing permissions management options.

Besides, DMM enter legally binding agreements with their clients and such agreements specify the duties of each party. Reputable DMM will always state in the contract they enter with a client that it is against the law of the jurisdiction(s) they operate in and against their business practices to temper with their client’s funds. In addition to this, DMM put their reputation on the line as they operate in an industry in which trust is paramount. Any lawsuit would be detrimental to the image of the DMM.

The article continues in Part 2.

   

Traders ALWAYS come first on MCS.

Thank you.

           

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Published 15 days ago