Understanding the Costs of Proprietary Market Making

The proprietary market making model is often portrayed as free of charge because trading firms usually do not take direct service fees.

However, it does entail three types of indirect costs:

  • the interest-free loan provided by the token project to the proprietary trader;

  • the call option’s primary impact on the token issuer; as well as

  • the call option’s secondary impact on all token holders, affecting the token’s price.

    Token loan without interest

    The proprietary market making firm first takes a token loan from the project.

    This loan can represent a sizable share, ranging between 2% and 4% of the total token supply. Sometimes even higher portions might be required from crypto projects.

    The market maker does not pay interest on this loan. Hence a project essentially gives away a large share of its tokens without compensation which it could otherwise use. This opportunity cost is an indirect cost of proprietary trading.

    The level of transparency a market maker provides is of utmost importance.

    If the proprietary trader’s activities happen in a black box, without sufficient oversight from a token project, the risk of conflict of interest becomes apparent. Because the trader is in control of the tokens, it may use the assets to benefit itself, and not the client.

    The call option’s primary impact

    The call option is a contractual right of the market maker to purchase the tokens in its possession. Its primary impact is that it allows the trading firm to buy all the tokens at a price negotiated before the start of its market-making activities. It obligates the token project to sell the tokens it had lent to the proprietary trader. Exercising the call option also terminates the contract, causing uncertainty.

    Trading firms usually request long-term contracts. While 6-month contracts may be offered to larger token projects, it is usually one or even multiple years that trading firms set as contractual terms.

    The call option’s price level may increase overtime as a positive incentive for the market maker. This can help reduce the primary impact of the call option in the long run.

    The call option’s secondary impact

    Theoretically, a non-transparent proprietary trader may decide to sell the tokens it had acquired all at once to instantly profit from the difference between the token’s call option price and the market price. 

    While such market-making conduct may be rare, if it happens, this secondary impact of the call option can affect the token price very negatively. All tokens in circulation lose their value — impacting both the project as well as the community and investors who own them.

A real-life example showing a token’s price before and after a proprietary market maker ends its support. (Source: CoinGecko)
A real-life example showing a token’s price before and after a proprietary market maker ends its support. (Source: CoinGecko)

Why proprietary market making?

Taken together, the outcomes and the impact of proprietary market making vary widely. Its cost structure is difficult to calculate.

Using it may not cost extra to token projects — but that is almost only true if the token’s price is falling. Nevertheless, the worst case scenario may turn out to be very expensive: giving up a significant portion of the digital asset’s supply may cost a crypto issuer millions of dollars worth of value.

Hence this traditional approach is most likely not optimal for most projects. Usually, either new, smaller projects or well-established, bigger ones that choose proprietary market making consciously. The vast majority of crypto projects might find the Market Making as a Service (MMaaS) model more beneficial.

MMaaS is a more capital efficient, calculable solution to provide reliable liquidity that can outperform the proprietary model in the long run. Coupled with the right transparency and compliance solutions, MMaaS has the potential to steady the digital asset ecosystem. Ultimately, it is the new standard of market making that can help mainstream crypto and bring about a tokenized global economy.

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