What is ‘Market Making’ and why does it matter?
Savvy requires market makers to ensure the smoothest experience for our users, but what are market makers and why are they important to DeFi?
Market makers provide tokens (often referred to as liquidity) to liquidity pools (local pairings of two or more tokens). These liquidity pools are often part of a decentralized exchange and facilitate swapping one token for another. For example, if I wanted to swap my USDC for ETH, I would find an ETH-USDC pool. I could then deposit USDC and receive ETH in return.
But why would anyone choose to market make, and why is it important to yield farmers?
In short, market makers provide liquidity in order to earn a return. In the example above, someone provided the ETH and USDC for me to exchange my USDC for ETH. The provider of the liquidity is the market maker. When traders swap tokens using the market maker’s liquidity, market makers earn a portion of the swap fees.
In traditional financial markets, market makers facilitate trading by maintaining an inventory of assets and providing continuous buy and sell orders to ensure market liquidity. Similarly, in DeFi, market makers play a vital role in ensuring liquidity and efficient price discovery.
Here’s an overview of how market making works in DeFi:
Liquidity Pool Creation
Market makers contribute tokens to a liquidity pool. These pools consist of smart contracts that hold funds and allow users to trade tokens directly against the pool’s reserves.
Pricing
The liquidity pool utilizes an algorithm to determine token prices based on the ratio of the tokens within the pool. This algorithm often follows a constant product model, such as the Concentrated Liquidity Automated Market Maker (CLAMM) formula used by platforms like Trader Joe.
Order Execution
Traders can interact with the liquidity pool by submitting transactions to buy or sell tokens. These transactions are executed directly against the liquidity pool and are processed automatically by the smart contracts.
Swapping
When a trade occurs, tokens are swapped within the liquidity pool. The pool balances are adjusted based on the token amounts bought or sold, ensuring that the pool maintains an appropriate ratio of assets.
Fees and Incentives
Market makers receive fees for providing liquidity to the pool. These fees are paid by traders as a percentage of the trading volume and are distributed proportionally to the market makers based on their contribution to the liquidity pool.
The goal of market making in DeFi is to improve liquidity and reduce price slippage, which is the difference between the expected price and the executed price due to insufficient liquidity. Market makers earn profits through trading fees, and they also benefit from any arbitrage opportunities that may arise from price discrepancies between different DEXs or liquidity pools.
Why did Savvy wait until now to release an educational content piece around market making, you ask?
There must be a big announcement right around the corner… stay tuned!
