Thread by @0xRyuzaki

gm crypto twitter

thought I'd kick things off by dropping some knowledge on electronic market making

a thread on how institutions are built by programming computers to buy low sell high

absolute basics:

market makers ("MMs") provide liquidity to a market by posting orders on the LOB

they buy slightly below the market price and sell slightly above it, i.e. if mid is $100 they post bids at $99, asks at $101, and make $2q per round trip (q = quantity traded)

I won't explain too many basics beyond that because it's been done elsewhere and I want to get into the good stuff

if terminology in the last tweet was confusing or you are a total n00b read this real quick to get up to speed
investopedia.com/terms/m/market…

if you have direct market access, you can code a bot to post LOs for you and effectively be a MM

and in crypto, all exchanges have free APIs so there are really no (financial) barriers to entry

so a question: what stops just anyone from doing this and printing infinite money?

the answer: you'll blow your account up very fast

if you do this naively, i.e. just posting LOs at the best bid and ask all the time, you lose money basically 100% of the time

pictured is a simulation of this strategy run on high volume stocks, clearly no bueno

why is this so bad? aren't you profiting from spreads?

pause to think about it before I give the answer

if you stand willing to buy or sell at the best prices all the time, what can go wrong?

ok a hint: what happens if the market tanks?

who's gonna be buying all that shit right as it's nuking?

that's right, your dumb ass

and if it starts mooning, you're gonna be selling right when you'd make more money holding

basically with every trade you get filled, there's a decent chance you're gonna be on the wrong side of it

the old saying: "I don't wanna be in any club that'll have me as a member"

this is formally known as adverse selection + inventory risk

adverse selection = your counterparty is informed and you're def on the wrong side of the trade

inventory risk = your book is skewed long/short due to an imbalance in buyers/sellers (you'd like to be delta neutral)

also note that if you're familiar with AMMs, what I'm talking about is the same concept as impermanent loss

generally the rewards have to be super high to compensate LPs for the IL, which is always bound to happen over enough time (excluding like stablecoin pools)

so how do you fix this?

there are roughly two ways

(1) you can try to predict the direction of the market over short time frames and trade with it

(2) you can adjust your quotes dynamically to manage your inventory, keeping your market risk low while capturing spreads

for now let's say that (1) is really hard and we don't wanna do it (if you can tho my DMs are open)

in theory a solution for (2) is all we need

we'll have a small net long/short delta as our orders get hit, but it'll be contained and revert to 0 over time

so that's the basic game we're playing as a MM: manage inventory risk so we can stay in business

it's a lot like selling options or insurance - you make small premiums (spreads) most of the time and occasionally lose big on tail risk events

markets and LOBs are dynamic, stochastic things, so building these models can involve a lot of math and statistics

hence most MMs are considered quant firms (though not all quant firms are necessarily MMs)

in crypto there are @AlamedaTrabucco, @wintermute_t, @mgnr_io, @B2C2Group, @jumptrading, and many more operating as liquidity providers and running these strategies across hundreds of markets and exchanges

all staffed with galaxy brains and for good reason

if you (yes you, anon) wanted to do this for yourself, the minimum you'd need is a model for managing inventory risk and software to place LOs orders for you on an exchange according to your strategy

for software BitMEX has a good starting point: github.com/BitMEX/sample-…

the model part is where it gets harder

if this gets any interest I'll follow up with an ELI5 thread on the math behind a classical model from academia (Avellaneda & Stoikov)

it isn't the full picture, but it's definitely a strong starting point to being profitable as a MM