Market making is the process of determining prices for financial assets and simultaneously creating liquidity for these instruments. It is a service that many financial institutions provide to their clients.
A market maker provides liquidity for a given asset by meeting the buying and selling requests of traders. This is done through an order book and an order matching system, which showcases the prices at which traders wish to purchase or sell an asset.
While DeFi does not allow a traditional market maker, it has implemented an alternative mechanism to ensure sufficient liquidity for its users. This is called an Automated Defi Market Making (AMM), and is used by a number of top DeFi exchanges, such as Uniswap, SushiSwap, PancakeSwap, Curve Finance and Balancer.
The primary function of an AMM is to create a liquidity pool for tokens. This is achieved by facilitating transactions between users via an automatic market making smart contract. The AMM will then receive fees for facilitating these trades, which is split evenly amongst all participants in the liquidity pool. The more tokens a liquidity provider has in their pool, the more fees they will receive.
Unlike regular market makers, AMMs do not require a large amount of capital to operate. They can be operated by anyone who has a wallet with a sufficient amount of crypto to stake in the underlying tokens.
However, this is not always a risk-free process. Liquidity providers can lose some of their invested funds if the price of their tokens deviates from the external market by a certain percentage. This is called an Impermanent Loss and may be a problem for some traders.
Another service that market makers may provide is arbitrage, which allows users to buy and sell tokens at different prices across a number of exchanges. This is a valuable service in some cases as it provides an additional way to earn trading fees while also reducing the cost of capital for the liquidity provider.
While arbitrage is a useful service in most ordinary markets, it has not become as common on DEXs due to lower liquidity levels in some of these platforms. This is why some DEXs, like Symbiosis Finance, have developed a multi-chain liquidity protocol that pools liquidity from several blockchain networks to make it easier for traders to find a suitable cross-chain bridge.
In addition, some DEXs also reward market makers with governance tokens in return for creating liquidity. These tokens are used by relayers and DAOs to participate in consensus and process swaps on the network.
Aside from providing a wide range of services, many DEXs also offer user-friendly features that can be beneficial to both novice and experienced crypto investors. These include an automatic exchange, a wallet that does not require user custody, and a built-in exchange platform for trading tokens. Some DEXs have also started experimenting with lending and lending-token exchanges. This is a form of microfinance and an example of how the cryptocurrency industry can move beyond the centralized model to build a truly decentralised ecosystem.
