Understanding Liquidity: How does Market Making work?

Crypto Market Making

Liquidity Provision

7 minutes

Liquidity is the silent engine of crypto markets. Market makers use algorithms, speed and deep order books to ensure seamless trading, tight spreads and stable pricing, even during volatility.

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Imagine a crypto exchange’s order book as a bustling marketplace ecosystem. Buyers and sellers congregate at different price levels, like merchants and customers haggling in a bazaar. Liquidity is the invisible medium that keeps this ecosystem vibrant – the silent force ensuring trades happen smoothly, continuously and at fair prices. When liquidity is plentiful, markets function efficiently: price differences between buyers and sellers are small, large orders hardly move prices, and trading feels as seamless as traffic flowing freely on a wide highway. In contrast, without sufficient liquidity, even a modest trade can feel like a large truck on a narrow road, causing slippage and sudden jolts in price. It’s no surprise that “liquidity is fundamental for cryptocurrency trading, influencing efficiency and stability”. High liquidity means an asset can be bought or sold quickly without significant costs or price dislocations, characterised by tight spreads, deep order books, and quick trade execution. In short, liquidity is the source of any healthy token market, underpinning every transaction from a casual trade to an institutional order.

The Order Book: Where Liquidity Lives

On a centralised exchange (CEX), the order book is a real-time ledger of all buy and sell orders for a trading pair. It’s often visualised as two lists – bids (buyers’ offers) on one side and asks (sellers’ offers) on the other. The bid price is the highest price someone is willing to pay for the asset, while the ask price is the lowest price someone is willing to accept to sell. The difference between the two is the bid-ask spread (or just “spread”). In a liquid market, this spread is extremely narrow. In fact, a smaller spread means the market is more liquid, as there’s strong competition between buyers and sellers converging on a fair price. For example, major Bitcoin pairs often have spreads just a few basis points wide, sometimes under 0.10% – thanks to intense liquidity provision on top exchanges. The midpoint between bid and ask (the mid-price) moves only slightly with each trade when liquidity is robust, because abundant buy and sell orders are waiting to absorb any imbalances.

Market depth is another hallmark of liquidity. Depth refers to the availability of sizable orders at many price levels above and below the current price. If an order book has thousands of units queued on both sides within, say, 1% of the mid-price, the market can absorb a large buy or sell with minimal slippage (price impact). In other words, deep order books act like shock absorbers: they soak up big trades without letting the price skid out of control. Liquidity and volatility are two sides of the coin – markets are most volatile when liquidity is low, because with less depth, prices have “less support” and can swing wildly on modest volumes. Conversely, tight spreads and thick market depth keep prices stable and trading costs low. Traders feel confident they can enter or exit positions at their desired prices with minimal slippage, thanks to the continuous presence of counterparties.

CEX Liquidity Architecture

Who actually provides this liquidity? In centralised crypto markets, market makers are the unsung heroes (or as Adam Smith might say, the “invisible hand”) ensuring there’s always someone on the other side of a trade. A market maker’s job is straightforward to describe but complex to execute: they continuously quote both buy and sell orders for a token, at various price levels, to keep the market active and orderly. In essence, a market maker is “making a market” in the asset – if you want to sell, they’ll buy; if you want to buy, they’ll sell. By placing orders on both sides of the order book, they ensure there’s always a match available for incoming orders, enhancing the asset’s liquidity.

Crucially, legitimate market makers are not in the business of randomly pumping prices or “faking” volume; their goal is to keep the market tradable and efficient. They profit from the spread (buying slightly below the mid-price and selling above it), but they earn this small margin by providing a valuable service: tighter spreads and deeper books for everyone. “A narrower spread generally indicates a more liquid market, whereas a wider spread suggests less liquidity and higher trading costs,” as one industry expert explains. It’s the market maker’s role to keep that spread as tight as possible without incurring losses. In highly competitive markets like BTC/USDT on major exchanges, this often means quoting buy/sell prices that are only a few dollars, or even cents apart on a $100,000 asset – a testament to the intense liquidity provision at play.

Operations of Liquidity Providers (Market Makers)

1. Latency & Order Execution Risk

A recent arXiv study (May 2025) highlights that even 30–100 ms of delay between quote decision and execution can lead to “undesired inventory accumulation” or missed trades. To mitigate this, firms train reinforcement learning (RL) agents (e.g., Relaver) that anticipate latency and adjust order strategies accordingly.

Earlier research (2018) confirms that latency-aware algorithms significantly increase profitability by reducing adverse fills and helping maintain balanced inventory.

2. Intelligent Inventory & Hedging Strategies

Research in CFD and dealer markets (2023) finds that optimal market-making algorithms dynamically adjust hedging intensity based on market volatility, balancing risk and cost for improved performance.

Foundational work shows that optimal quote positioning can be mathematically derived to control inventory risk using utility-maximising models.

3. Ultra-Low Latency & Co-Location Infrastructure

In traditional markets, “low latency” typically means sub-millisecond; each millisecond can be worth tens of millions annually. Firms invest in co-located servers, hardware acceleration, direct-market access lines and microwave links to shave latency and enable near-instant reaction to market moves. These techniques are directly applicable in crypto, where microsecond reactiveness enables cross-exchange arbitrage and tight quoting.

4. Cross-Exchange Arbitrage & Latency Arbitrage

Latency arbitrage in crypto leverages small inter-exchange price differences that only exist for milliseconds. A 2020 UK FCA study estimates global latency arb profits near $5 billion annually.

By monitoring fragmented liquidity and exploiting temporary mispricings, market maker bots quickly align prices, ensuring tight spreads network-wide.

5. High-Frequency Trading Foundations in Algorithmic Market Making

HFT firms, encompassing many market makers, placed 10–40% of equity volume, relying on speed and algorithms to profit from tiny price differences. Their techniques, mean reversion, trend tracking and statistical arbitrage, drive the automated quoting and liquidity strategies seen in crypto market-making.

Each of the above contributions reinforces market health. Together, they ensure that a token market remains liquid and orderly – traders can execute even large orders with minimal price impact, and exchanges benefit from stable, tight pricing that attracts more volume. Liquidity begets liquidity: when spreads are low and depth is high, more participants are willing to trade, which further improves liquidity in a virtuous cycle.

Why Liquidity Is the Bedrock of Scalable Markets

For token teams and exchange operators, liquidity isn’t just a technical metric. it’s the enabler of growth. A token with strong liquidity will have a reliable market price, giving investors confidence and reducing the risk of sudden crashes. Tight spreads and low slippage make the token more attractive to trade, which can lead to higher volumes and more investor participation. In contrast, a token listed on an exchange without market makers can suffer wide spreads and erratic price jumps, deterring serious traders. Liquidity also underpins price stability. Market makers, by stepping in as buyers during sell-offs and sellers during frenzied buys, help smooth out what could otherwise be jagged price movements. This stabilising effect is crucial, especially around events like new exchange listings or big news releases. It prevents a situation where, for example, a rush of buy orders shoots the price up 100% only to crash back down; instead, with liquidity provision, prices adjust more gradually and sustainably.

Moreover, liquidity is essential for price discovery and fair valuation. A liquid market with many participants (including arbitrageurs) will quickly arbitrage away any mispricing. This means the token’s price is more likely to reflect its true value based on available information. Illiquid markets, by contrast, can be easily manipulated or may lag in reflecting news, because trading is too sparse to find equilibrium. Market liquidity and price discovery go hand in hand, contributing to a more transparent and reliable market for all participants.

There’s also a network effect dimension: Exchanges with deeper liquidity pools tend to attract more traders, creating a self-reinforcing cycle. This is why exchanges often incentivise market makers – through rebate programs or even formal market-making partnerships – to foster liquidity on their platform. Healthy liquidity not only improves the user experience (no one enjoys seeing a 5% price impact warning on a modest trade) but also enhances the exchange’s reputation. In the highly fragmented crypto industry, traders will gravitate to venues where they trust they can execute efficiently. Having strong liquidity across regional exchanges can also support regional market growth, ensuring that traders in different geographies have access to the same seamless trading experience.

Conclusion: Liquidity in Action

Liquidity provision truly is the silent force behind every trade – often unseen, often taken for granted, yet absolutely essential. It’s what allows token markets to scale from thousands to billions in daily volume without breaking a sweat. The order book ecosystem thrives when fed with ample liquidity: tight spreads, deep depth, low slippage and steady price discovery are the visible fruits of this invisible hand. As the crypto markets mature, the role of professional liquidity providers and market makers has only grown more pivotal in ensuring resilience and efficiency, even through volatile times.