If you are not a trader, chances are that you only see one side of the market — investors, day-traders, speculators. All of them are called market takers. They take liquidity from the market. Their goal is to make money on their trades afterwards, whether it is in minutes, days or years.
Two things are important to market takers:
· Liquidity, or being able to execute the size they want at cheapest price possible.
· Immediacy, meaning being able to execute the trade as quick as possible.
Market takers intentionally take risks associated with their positions. They buy or sell different financial instruments because they are willing to take the associated risk and anticipate profit in future.
Market makers are on the other side of the equation, they are the “invisible hand” of financial markets. Whatever asset you are buying or selling, the odds are you’ll trade against one of them. Market makers provide liquidity and make money by receiving the market spread. The spread is the difference between the bid and ask (or bid-offer) prices on the market, or simply the difference between the buy and sell price, like when you are exchanging money in a currency exchange kiosk. The difference lies in how the exchange kiosks make money. Similarly, spread is how market makers make money.
Let's say an asset is currently trading with an ASK Price of 50 and a BID price of 45. Most of us understand this means that if we want to purchase this asset we will have to pay 50 and if we were to sell the asset we would be paid 45. This is where Market-Makers profit and those profits would be the spread or in this crude example a profit of 5.
In liquid markets with many buyers, sellers and market makers, the spreads are small. Market makers need to make a very large number of trades to get profits. They use very advanced quantitative algorithms to take very short term positions — these could be hours, minutes or seconds. The higher the asset volatility (i.e. enough movement in the market) and the higher the trading volumes, the more trades market makers are able to make, and the more profit they make.
However, market making is not risk-free. Crypto market makers take on risk at the whim of outside world of market takers. They make profit initially but manage their risks afterwards. If there is an even number of buyers and sellers on a screen, they would have almost no risk by the end of the day, while a FOMO rally with no sellers or a panic sell would typically be a challenging situation for them.
What is a cost to a market taker is the primary source of income to the market maker. As in any many other businesses, market makers face a trade-off between the margins earned and the volumes traded. And as in any other business, if the margins are high, competition comes in. Unfortunately, it can also result in a chicken-and-egg situation where there is no volume because the spread is too wide and the market maker is unwilling to take more risk by tightening the spread until he gets the confirmation that there will be enough volume going through. In these situations, the parties most interested in generating liquidity (asset issuers and exchanges) create incentives for market makers to provide better prices. Exchanges generally create more favourable conditions for market makers by reducing or eliminating trading fees. For asset issuers, paying a monetary stipend for a definite period of time is the most straightforward way to incentivise provision of liquidity.
So to summarize:
Market-Makers = Provide liquidity, make profits immediately and manage risk later, profit from high volatility and trading volume
Market-Takers = Take liquidity, Take risk now in hopes of profiting layer, profit from liquidity and immediate availability in the markets
Now the assets that makeup the "Top 100 By Market Share" charts we see on CoinMarketCap and CoinGecko usually have large enough trading volumes and thereby liquidity that Market-Makers can typically compete against each other with little or no cost and limited risk. What we see when it comes to smaller and more obscure assets and trading pairs though is a lack of liquidity or a liquidity vacuum because there simply aren't enough Market-Makers providing them with the necessary liquidity.
All traders at some point have seen or will see cases of smaller exchanges or assets suffering from a lack of liquidity or liquidity vacuum. It looks a lot like the example below. Wide spreads really limit the number of strategies a trader can adopt. A 5% wide spread means you will have to pay 2.5% to initiate the trade and another 2.5% to close it. Secondly, illiquid markets are much easier to disrupt. Even a relatively small seller can wreak havoc, potentially triggering other investors’ stop loss orders resulting in a panic sell. You might think a buyer won’t create a similar problem, but think twice. A sudden rally in an illiquid token could trigger a bunch of FOMO investors to join, resulting in an unsustainable rally and pump-and-dump accusations in the end.
See the huge spread between the Ask and Bid prices? Note that the trading volume reported for this coin is approx $8 USD/24HRS!! (A more extreme example but it paints the picture clearly!)
SO, how is liquidity important to us as successful traders?
Increased Liquidity Attracts More Investors
The tighter the market for a given token, the cheaper it is for a new investor to trade in and out of their positions. That in turn can attract a more diverse trading community (including institutional investors) employing very different strategies, which would otherwise not be feasible. Unlike the larger spread in the example that I explained above, tightening the market to 0.5–1% and less spread will attract more sophisticated investors who can do technical analysis, correlation arbitrage versus other tokens. More liquid markets are also less susceptible to large price disturbances due to big orders.
Liquidity Breeds Liquidity
Once the ecosystem of investors starts growing, an amazing thing happens — there are more orders in the order book, meaning even better liquidity for market takers. Since the number of market takers increases, market makers start increasing the size on their orders (volume is their friend, remember). And as the trading volume goes up, more market makers will show up for free, lured by promising numbers.
Volumes and investor confidence drive price up
Higher volumes would inevitably make the project noticeable, bringing in lovers (and haters). Vast majority of that interest will result in more people considering the token as an investment. Higher demand would drive the price up. Lack of sudden price movements further boosts the investor confidence and demand. High trading volumes would also help the token economics as it is easier to sell your project to a consumer or new business partner when there is significant trading going on in the background.
