Liquidity at your fingertips: Understanding Traditional Market Makers and Automated Market Makers

The Robinhood crisis of 2021 brought to light a number of issues with market making, and as a result, this practice has gained a bad reputation. However, Market making is an essential part of the financial system, and for decades it has played an important role in providing liquidity to the markets. Yet, the actions of certain market makers in the Robinhood crisis exposed a number of ethical and regulatory violations, leading to a loss of trust in this practice. My article today will delve into the details of the Robinhood crisis, the history of market making as a whole and why automated market makers are interesting to keep an eye out for and how they could have prevented a Robinhood-like situation from arising.

Background

The Robinhood market-making crisis refers to the events of January 2021, when the popular retail trading platform, Robinhood, faced criticism and a lawsuit over its market making practices. At the heart of the crisis was the relationship between Robinhood and Citadel, a prominent market maker.

According to reports, Robinhood was routing a significant portion of its customer orders to Citadel, which then executed those trades through its own market-making subsidiary, Citadel Securities. In exchange for this business, Citadel paid Robinhood for order flow, which is a controversial practice where a broker receives payment from a market maker or specialist firm in exchange for routing customer orders to them. This would have led to Robinhood making money without its customers even knowing about it.

?The concern is that this relationship created a conflict of interest for Robinhood, as it had the incentive to route orders to Citadel, even if it was not the best execution for its customers. Critics argue that this led to worse trade execution and higher costs for Robinhood's customers. Furthermore, during the events that occurred at GameStop and other companies, Robinhood restricted buying of those stocks. This generated a big outrage from the investors, who felt like the system was rigged against them.

In addition, the crisis also brought attention to the fact that Robinhood had not been transparent about its market-making practices and its relationship with Citadel. Many customers were unaware that their orders were being routed to Citadel, and that Robinhood was receiving payment for order flow. The lack of transparency has led to concerns about the alignment of interests between Robinhood and its customers.

The scandal resulted in lawsuits and calls for regulatory changes, Robinhood was fined by FINRA [the Financial Industry Regulatory Authority, a government-authorized not-for-profit organization that oversees U.S. broker-dealers] and other regulators for their failures in its handling of the events, while Citadel and other market makers also faced scrutiny for their practices. Some of the claims alleged that Citadel used the information provided by Robinhood to trade against its own customers, and also that the market maker had a role in the halt of trading of certain stocks during the events.

?As a result of this scandal, many investors have lost trust in the practice of market making and have become more cautious about the hidden costs and potential conflicts of interest that may exist in the market-making industry. Moreover, some regulators have taken actions to address the situation, including proposing new regulations around market makers' and brokers' handling of customer orders, and the level of transparency they are required to provide.

Overall, the Robinhood market-making crisis has brought to light important issues surrounding market-making and the potential conflicts of interest that can arise when a broker-dealer is receiving payment for order flow. It highlights the need for proper oversight, transparency, and regulations to ensure that market making serves the interests of investors and not just the intermediaries or market makers.

But what is market making?

Is there anything that could have prevented this from happening?

Overview of Market Making

Market making has a long history that dates back to the inception of financial markets. It is the process of buying and selling securities or other financial instruments in order to facilitate trading and provide liquidity to the market.

The origins of market making can be traced back to the stock exchange floors of the 19th century, where brokers and traders would stand in a central location known as the "trading pit" and buy and sell securities with each other. As financial markets evolved, market makers began to use technology to execute trades electronically, and today, most market-making is done using algorithms and high-speed computers.

Market makers play a critical role in financial markets by providing liquidity and helping to ensure that prices remain efficient and fair. They also help to reduce volatility in the market by continuously buying and selling securities, even when there is little trading activity.

In modern times, market making is a common practice in many financial markets, including the stock market, the bond market, and the foreign exchange market. It is also common in more complex financial instruments such as derivatives, which are contracts that derive their value from the performance of an underlying asset or index.

Given below is a short timeline showing the development of market making :-

1792: The New York Stock Exchange (NYSE) is founded, and market making begins to take place on the floor of the exchange. Brokers and traders would gather in the trading pit and buy and sell securities with each other.

1971: The Chicago Board Options Exchange (CBOE) is founded, and options trading begins. Market makers play a crucial role in the options market by providing liquidity and helping to set prices.

1973: The NYSE introduces the Designated Market Maker (DMM) system, which assigns a specific market maker to each listed stock. The DMM is responsible for maintaining an orderly market in the stock and facilitating trading.

1980s: Electronic trading begins to take hold in financial markets, and market makers begin to use technology to execute trades.

2007: The NYSE introduces an electronic trading platform known as NYSE Arca, which allows market makers to execute trades electronically.

2010s: High-frequency trading becomes more prevalent, and market makers increasingly use algorithms and high-speed computers to execute trades.

Market making has evolved significantly over the past two centuries, from a manual process on the floor of a stock exchange to a highly automated and technology-driven process that takes place electronically. Despite these changes, market makers continue to play a vital role in financial markets by providing liquidity and helping to ensure that prices remain efficient and fair.

?Role of Market makers

Market makers play a critical role in financial markets by providing liquidity and helping to ensure that prices remain efficient and fair. They do this by continuously buying and selling securities, even when there is little trading activity.

The main advantage of having market makers is that they help to ensure that there is always someone willing to buy or sell a particular security. This helps to reduce volatility in the market and makes it easier for investors to buy and sell securities. Market makers also help to provide price discovery, which is the process of determining the fair market value of a security.

There are also some potential disadvantages to having market makers. One concern is that market makers may have an unfair advantage over other traders because they have access to more information about the market and the orders being placed. This can lead to conflicts of interest and may result in market makers profiting at the expense of other traders. In addition, market makers may charge higher fees for their services, which can reduce returns for investors..

Here is an example of how market making would work for Tesla shares:-

1. ?The market maker receives an order to buy 100 shares of Tesla stock at a price of $800 per share.
2. The market maker checks its inventory of Tesla shares and determines that it has 50 shares available for sale.?
3. The market maker quotes a price of $800.01 per share for the remaining 50 shares, and the order is partially filled.
4. The market maker then looks for other market participants who are willing to sell Tesla shares at a price of $800 or lower.
5. The market maker finds a seller who is willing to sell 50 Tesla shares at a price of $799.50 per share.
6. The market maker buys the 50 Tesla shares from the seller and sells them to the original buyer at a price of $800 per share, completing the order.
7. The market maker now has an inventory of 100 Tesla shares, which it will continue to buy and sell as new orders come in.
8. This is just one example of how a market maker might facilitate trading in Tesla shares, but the exact process can vary depending on the market conditions and the specific needs of the market maker

Market makers play a crucial role in the financial system by providing liquidity to the markets. They do this by standing ready to buy and sell securities at any time, which helps to ensure that there is always someone available to trade with and that there are enough buyers and sellers to keep the markets functioning smoothly. If market makers were not present, it is likely that the liquidity in the markets would decrease, which could lead to a number of consequences.

For example, without market makers, it might be more difficult for investors to buy or sell securities when they want to, which could lead to increased price volatility and greater difficulty in executing trades. This could make it harder for investors to manage their portfolios and could lead to a decline in confidence in the markets. Additionally, without market makers, the overall efficiency of the financial system could be impaired, as there might not be enough buyers and sellers to facilitate the smooth flow of trade. This could lead to reduced economic activity and could have negative consequences for businesses and consumers.

Automated Market Makers

An automated market maker (AMM) is a type of algorithm that is used to create liquidity in a market by automatically setting the prices of assets based on supply and demand. The most well-known example of an AMM is the Uniswap protocol, which is a decentralized exchange built on the Ethereum blockchain.

?AMMs use a mathematical formula to determine the prices of assets based on the amount of those assets that are being held in a particular market. For example, if the demand for a certain asset increases, the price of that asset will also increase. Conversely, if the demand for an asset decreases, the price will decrease.

?AMMs are particularly useful in decentralized finance (DeFi) applications because they allow for the creation of markets for assets that may not have a centralized exchange or market maker. Additionally, because AMMs are decentralized, they are not controlled by any single entity, which can make them more resistant to censorship and manipulation.

?They work on the idea of providing liquidity in a pool, the users trade with other users and the algorithm adjusts the price dynamically to balance the buy and sell order. Incentivizing liquidity providers is also an important factor, this is done by using a token that represents an ownership in the liquidity pool.

?One downside of an AMM is that their prices can be less accurate than traditional market makers, because they are based on a mathematical formula rather than human judgement. Additionally, They also incurs slippage when trading as well.

?The mathematical formula that automated market makers (AMMs) use to determine the prices of assets is called a constant function market maker (CFMM) formula. The most widely used version of this formula is known as the constant product market maker (CPMM) formula.

?The CPMM formula works by maintaining a constant product of the reserves of the assets in the market. The reserves refer to the amount of the assets being held in the market by the AMM. The constant product is determined by a parameter known as the liquidity parameter, or "k" for short.

?The formula can be represented as:

x*y = k

Where x and y are the reserves of two different assets being traded on the market, and k is the liquidity parameter.

?The prices of the assets are then determined based on the ratio of their reserves in the market. For example, if the reserves of asset A are twice as large as the reserves of asset B, the price of asset A will be half the price of asset B.

?In addition to CPMM, there are other types of AMMs as well, some use a more complex formula like a logarithmic market scoring rule, balancer pools use a quadratic function to adjust the price, etc. They all have different mechanisms to calculate the price, but the concept of liquidity and the constant product remains the same.

?It's also worth noting that, in practice, some AMMs may use slightly different variations of these formulas or different formulas altogether. But the basic idea behind all of them is to maintain a balance between the supply and demand of assets, using a mathematical formula to determine prices based on the reserves of the assets being traded.

There are several notable automated market makers (AMMs) in the cryptocurrency space, each with its own unique features and advantages. Here are a few examples:

1. Uniswap: One of the most well-known AMMs, Uniswap is built on the Ethereum blockchain and allows anyone to create a market for any ERC-20 token. It uses a constant product market maker (CPMM) mechanism, which balances liquidity pools to maintain a constant product of the token prices.
2. SushiSwap: SushiSwap is a fork of Uniswap that aims to improve upon the original by adding new features such as staking, yield farming, and community governance. SUSHI token is used as an governance token to vote on protocol upgrades.
3. Balancer: Balancer is another popular AMM that allows users to create custom pools with multiple assets and adjustable weights. It also allows for the creation of smart pools that can be programmed to automatically rebalance based on certain conditions.
4. Bancor: Bancor is an AMM that utilizes an algorithm known as a "connector" to automatically calculate the price of tokens based on their supply and demand. One of its main selling points is the ability for any token to be instantly convertible to any other token in the network through its smart contracts, allowing for greater liquidity.
5. Curve: Curve is a stablecoin-focused AMM that aims to provide high liquidity and low slippage for stablecoin trading pairs. It uses a unique liquidity provision mechanism called liquidity coding which allows for multiple pools for each token, known as "tracking the dollar".
6. PoolTogether: PoolTogether is a no-loss lottery built on Ethereum blockchain which allow users to save DAI together in a pool, and each week one lucky winner takes all. By holding DAI in the pool user can earn interest on their savings, and participate in the lottery with no chance of losing any of their savings.

Traditional market makers and AMMs have a number of differences. Traditional market makers are typically centralized and use human judgement to set prices, while AMMs are decentralized and use mathematical formulas to set prices. Additionally, traditional market makers typically require a large amount of capital to act as a market maker, while AMMs can be created and run by anyone with sufficient reserves and understanding of the formula. AMMs are also not subject to regulatory oversight and decentralized nature makes them more resistant to censorship and manipulation. However, the prices of assets on AMMs may be less accurate due to the reliance on mathematical formula, and they can have high slippage as traders are trading with other traders, not with the liquidity provider directly.

?Automated market makers (AMMs) have the potential to replace traditional market makers in certain circumstances. Here are a few reasons why AMMs can replace traditional market makers:

1. ?????Decentralization: Because AMMs are decentralized and run on blockchain technology, they are not controlled by any single entity. This makes them less susceptible to censorship and manipulation, which can be a concern with centralized market makers.
2. Lower barriers to entry: Traditional market makers typically require a large amount of capital to act as a market maker. In contrast, anyone with sufficient reserves and understanding of the formula can create and run an AMM.
3. Increased liquidity: Because AMMs use mathematical formulas to set prices based on supply and demand, they can create liquidity in markets where traditional market makers may not be present. This can make it easier for traders to buy and sell assets, which can increase market activity and improve overall efficiency.

However, there are also reasons why AMMs may not be able to replace traditional market makers in all circumstances:

1. Price accuracy: While AMMs use mathematical formulas to set prices, traditional market makers use human judgement. Human judgement can be more accurate than mathematical formulas, especially in cases where market conditions are complex or uncertain.
2. ?Slippage: When trading on an AMM, traders are trading with other traders, not directly with the liquidity providers. As a result, AMMs can have high slippage, which can make it more difficult to execute large trades.
3. ?Liquidity provision: Traditional market makers are also liquidity providers and they can provide liquidity directly to the traders, where as in AMMs the liquidity is provided by liquidity providers, which are separate entities. This can affect the overall liquidity of the market.
4. Regulation: Traditional market makers are typically subject to regulatory oversight. This can provide some level of protection for traders and market participants. AMMs, on the other hand, are not subject to regulatory oversight, which can be a concern for some traders.

Overall, AMMs have the potential to replace traditional market makers in certain circumstances, particularly in markets where decentralization and increased liquidity are important factors. However, they also have some limitations in terms of price accuracy and slippage that traditional market makers don't have. The use case of both will depend on the market, their features, and the participants preferences.

What we do know for certain is that AMM’s have had a profound impact on the digital asset space and would continue to because without them the cryptocurrency world would look like this :

1. Liquidity would be reduced: As mentioned before, one of the main advantages of AMMs is that they allow for trading to occur even when there are few buyers or sellers. Without AMMs, it would be much harder for small or new assets to get listed on centralized exchanges, and trading volume would be much lower. This would make it harder for people to buy or sell these assets, leading to higher spreads between bid and ask prices.
2. ?Trading would be less efficient: Because AMMs use mathematical formulas to determine prices based on the supply and demand of an asset, they can lead to more efficient trading. Without AMMs, prices would be based on the buy and sell orders of market participants, which can be affected by factors such as emotions, news, and speculation. This can lead to greater price volatility and less predictable markets.
3. ?Decentralization would be reduced: AMMs are decentralized, which means that they are not controlled by any single entity. This makes them less susceptible to hacking and manipulation. Without AMMs, trading would be largely dependent on centralized exchanges, which are vulnerable to hacking and fraud.
4. ?Limited options for trading: Without AMMs, options for trading for new or low liquidity assets would be limited. Most of the trading volume would be concentrated on major assets on centralized exchanges.
5. Maker-taker fee model would be dominant: Centralized exchanges typically use a maker-taker fee model in which makers, who add liquidity to the order book by placing limit orders, receive a reduced fee while takers, who remove liquidity by placing market orders, pay a higher fee. Without AMMs, the users would have to rely on this fee model, where the fees would be high and only centralized exchanges would be able to charge that.

AMM's, payment for order flow and the Robinhood crisis?

In my opinion, The payment for the order flow scandal that occurred with Robinhood, would not be possible with Automated Market Makers primary due to the following reasons:

1. Decentralized nature of AMMs: AMMs are built on decentralized blockchain networks, and the trades are processed by smart contracts. This means that there is no centralized intermediary, such as Robinhood, that can receive payment for order flow and route orders to market makers. Instead, the trades are executed automatically by the smart contract, and all market participants have access to the same information and trade on the same terms.
2. Transparent Pricing: AMMs use algorithms to determine the prices of assets, which are transparent and verifiable. This means that everyone can see how the prices are being set, and there is less opportunity for manipulation. In contrast, in the case of Robinhood, the pricing and routing of orders were not transparent, and the customers were not aware of the fact that their orders were being routed to market makers that were paying the highest payment for order flow.
3. Liquidity pools: AMMs use liquidity pools, which is a collection of assets contributed by multiple users, to match buyers and sellers, and the funds in these pools are accessible to anyone. In contrast, the market makers in Robinhood's case had a direct relationship with Robinhood and not the end-users, the liquidity was not publicly available for other market participants to access.
4. Automated and Algorithmic: AMMs use automated algorithms to match buyers and sellers, and to set prices, which reduces the potential for human error and manipulation. Market makers in Robinhood's case were able to use the payment for order flow to influence the prices and the routing of the orders which was a manipulative practice that would not be possible with AMMs. The smart contract and the algorithm that runs the AMM ensures that the trades are executed based on a set of pre-defined rules, removing the possibility of any individual or entity influencing the process for their own benefit.

You might be wondering what is payment for order flow....

Payment for order flow is a practice where a broker-dealer, such as Robinhood, receives payment from a market maker or a specialist firm in exchange for routing customer orders to them. This means that instead of sending the order to the market maker that will give the best execution, the broker will route the order to the market maker that offers the highest payment for order flow. This means that the broker may not be getting the best price for its customers, but it does mean that the broker is earning additional income from the market maker.

Payment for order flow is a controversial practice, and it has been the subject of much debate in the financial industry. Some argue that it is a necessary practice that helps to increase liquidity in the markets, while others argue that it is a conflict of interest that can lead to worse outcomes for customers.

From an academic perspective, Payment for order flow raises concerns about the alignment of interest between the brokerage firm and the retail investors. It creates potential conflicts of interest, since the brokerage firm is incentivized to send orders to those market makers that offer the highest payments, rather than to those that would provide the best execution. This could lead to higher trading costs, wider bid-ask spreads, and a reduction in the quality of trade execution.

Additionally, Payment for order flow can contribute to the concentration of market power among a small number of market makers, as it gives these market makers an incentive to offer higher payments, which in turn creates barriers to entry for new market makers. This can lead to less competition and higher costs for investors in the long run.

Overall, Payment for order flow is a complex issue that requires balancing competing interests. While it can help to increase liquidity in the markets, it also creates potential conflicts of interest that can lead to worse outcomes for customers. As such, it is important that regulators closely monitor and scrutinize the practice, to ensure that it is not being used to the disadvantage of investors, and that proper disclosures are in place to allow investors to make informed decisions.

In summary, the payment for order flow scandal that occurred with Robinhood was a result of a centralized intermediary with a lack of transparency and oversight, practices that would not be possible with AMMs as they operate in a decentralized and transparent environment with smart contract that ensures the proper execution of trades, while providing equal access and information to all participants in the market. This is why AMMs can mitigate the conflicts of interest and potential manipulation that arose in the Robinhood case.

Conclusion

The debate over the role of Automated Market Makers (AMMs) in the future of market making is an ongoing one. On one hand, AMMs have the potential to provide increased liquidity and efficiency in the markets, by using algorithms to automatically match buyers and sellers. They also have the potential to reduce barriers to entry for market making, as they can be set up and run by anyone with the necessary technical expertise, without the need for significant capital.

On the other hand, AMMs also have some limitations and potential downsides that are worth considering. For example, AMMs can be vulnerable to flash crashes and other types of market manipulation. Additionally, AMMs may not be able to provide the same level of expert judgment and market knowledge that human market makers can, which can result in less-than-optimal trade execution.

While AMMs may have the potential to revolutionize the market-making industry, it is important to consider both the potential benefits and limitations of this technology. The financial industry should approach the use of AMMs with caution, and ensure that they are properly regulated and transparent to protect the interest of the investors. The industry should also continue to monitor the developments of AMMs, and assess how they are impacting the markets, with the aim of finding the right balance between technology and human expertise for the best outcome for market participants.

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