Market making on futures exchanges is fundamental to ensuring liquidity. In this article, we explain how the process works and how we do it a little differently on Digitex.
Before explaining how market making works on the Digitex exchange, here’s a quick recap on exactly what “market making” means. Market making is where a company or individual quotes both a buy and sell price of a financial instrument, such as a futures market, hoping to make a profit on the bid-ask spread.
If the market maker manages to buy and sell the same amount of contracts and the price of the underlying instrument doesn’t change, the profit will be the difference between the bid price and the offer price.
Market making leads to tighter bid-ask spreads, providing liquidity and reducing slippage costs by making it easier for other market participants to enter and exit positions. All major stock exchanges and futures markets offer various different incentives to encourage market makers to continuously place bids and offers. These incentives can include reduced trading fees, faster access to information, faster trade execution and even the ability to back out of trades within the first 100 milliseconds of one of their bids being hit!
Essentially, market makers are often given a tangible advantage over other market participants that virtually guarantees their profitability in exchange for the liquidity they provide. In this way, the presence of market makers can actually make it harder for other traders to make a profit, despite the appearance of tighter bid-ask spreads and improved liquidity.
Market Making on Digitex
At Digitex, we are very aware of the need for active market making to make our futures markets liquid and attractive to traders. But, as with many other aspects of the futures trading business, we want to do market making slightly differently than normal.
We want to provide a fairer system that creates liquid markets and tight bid-ask spreads, but not at the expense of our regular traders. It’s important to us that we eliminate all mechanical edges working against regular traders so that normal people actually have a chance of making consistent profits.
Automated Market Makers
In the interests of our traders, we held back a very large number of tokens (200m DGTX which is 20% of total DGTX supply) from our ICO for the purpose of creating highly liquid futures markets on the Digitex Futures exchange.
This is actually a very high number compared to allocations from other exchanges–with even one-quarter or one-half (10% of the total supply) would make the exchange very liquid.
We will create this liquidity through market making on our own account, with the goal of breaking even overall. In this way our markets are liquid but regular traders aren’t being continually fleeced by insiders and actually have a chance of making consistent profits. Our in-house, automated market makers trade their own account with the clear goal of breaking even over time.
The Digitex automated market makers are hundreds of trading robots that access the exchange and submit trades programmatically through our API. Trades submitted by market makers receive no special treatment or privileges and are queued and executed exactly the same as any other trades submitted by human traders through the User Interface.
The market makers are coded to continuously place bids and offers of arbitrary quantities of futures contracts at and around the current Last Traded Price. Their trading algorithms tell them to follow the spot price of the underlying instrument, with varying degrees of aggression, with the goal of breaking even over a given time frame.
In short, their presence ensures highly liquid markets from day one, so that traders can get their orders filled with little to no slippage.
Wrapping it Up
Despite them not making a profit, the market makers are still making the highest and best use of their very large trading bank. This is because fair, commission-free futures markets that allow disciplined traders to make consistent profits will be very popular and attract large numbers of traders. Finally, they can actually grind out a real living from trading!
All these traders must own DGTX to participate and this creates demand and ensures the token efficiently captures the increasing value of a popular and liquid exchange. Despite automated market makers not make a trading profit in the strict definition of the word, the liquidity they provide is a catalyst for massive demand for DGTX that will significantly increase the value of their own trading bank.