The once-lucrative business of market-making in crypto, facilitating trades and profiting from the spread between buying and selling prices, has faced headwinds recently.
One major factor contributing to this decline is the heightened caution among investors following the crypto market’s downturn last year, which wiped out approximately $2 trillion in value, Bloomberg on Tuesday.
The has left a significant amount of digital assets stranded on collapsed platforms, making market-makers wary of potential future turmoil.
To mitigate these risks, the firms have adopted several strategies that, while reducing exposure, have also eroded profit margins, the Bloomberg report said.
One approach is diversifying activity across multiple cryptocurrency exchanges to avoid concentration risk.
Additionally, market-makers are increasingly storing digital assets off trading venues and using them as collateral to borrow tokens for deployment on crypto platforms.
This collateral is typically held with custodians or prime brokers, ensuring that only the borrowed tokens are exposed if an exchange were to fail.
Higher cost of business
Not surprisingly, risk-mitigation measures come at a cost.
According to Bloomberg, using intermediaries to manage collateral reduces profitability by 20% to 30% compared to leveraging coins directly with a trading platform.
Despite the decline in margins, market participants are recognizing the necessity of these strategies, acknowledging that higher costs are now an inherent part of doing business in the crypto market.
“The FTX debacle was a wake-up call for the industry,” Le Shi, head of trading at crypto-focused market-maker Auros told Bloomberg.
Shi admitted that risks associated with leaving digital assets on exchanges were not always a priority, but said that has now changed.
“[…] we understand higher cost is going to be a way of doing business now,” he said.
Market depth reveals lower liquidity
Meanwhile, an analysis of crypto exchange’s market depth, or the market’s ability to absorb large orders without impacting the price, has revealed that liquidity is far lower now compared to the bull-run during the pandemic era.
According to a note by crypto researcher Kaiko, the number of trades that fall within 2% of the mid-price of on exchanges is now down more than 60% since October of 2022.
“While this is partly due to structural reasons — market makers leaving the space after sustaining losses or permanently revising their risk management strategies after FTX — the low volatility environment is also playing a role in keeping liquidity providers out of the market,” Bloomberg cited the Kaiko note as saying.