Insights from my automated market making experiment with Uniswap

Markets

Jul 12

I think the democratization of market making is very important because today those profits are concentrated into a few technology firms and even worse brokers who are supposed to serve the customer. While markets are more accessible then ever before: market making in the established markets is I’m going to argue less accessible then ever because in the distant past a trader could put up a stake and get access to the trading floor. There is no doubt that the industry has advanced and should not go backwards: but the next step would be to allow retail traders the opportunity to provide liquidity with equal fill probability or equal spread rewards.

One might question why it is even relevant and the relevancy is that it is very difficult to make money from markets on the shortest time frames with limited capital which is what most retail traders want to do. And, this is where market making excels because profits are a function of volume thus allowing capital efficiency.

The first thing that impresses me is that automation is key because I have did the manual style market making which consist of adding and removing or working orders and it is very time intensive and stressful. Yet, the reality is that the discretionary value add is probably limited to some idea of the trading range and some idea of when to pull orders. The majority of the executions should be automated. It is worth noting the type of market making that Uniswap allows which is a pro-rata sharing of spread profits is not possible in retail style market making where the trader really tries to capitalize on the volatility to some extent whereas with Uniswap you can make profits from pure volume. While a retail trader can capture the spread, we know that most orders that do get filled will suffer from adverse selection.

As for my experiences with Uniswap, I am generating tangible profits. The ranges I have picked so far have worked well. While very worthwhile, the profits are not as much as I have generated from trend trading. However, the profits from market making tend to be greatest when my trending position isn’t doing well and vice versa: so somewhat complimentary. The greatest risk with market making is an impermanent loss becoming permeant: basically breaking your range and never returning too it or staying outside your range for a prolonged period of time . And, that’s why when I have engaged in manual market making in the past, I have only traded products that I am willing to hold long term. Because of the tail risk loss possibility, I don’t really know the viability or long run profit potential.

It is interesting to think about the ideal conditions for the various trading styles:

Market makers or primary liquidity provider: Market makers want a lot of volume transacted with about equal buy and sell orders. And, they want this to take place inside a trading range. The more predictable and tighter the range then the more capital efficiency the market maker can use and thus generate higher returns. Tight ranges with tons of volume are ideal. A very slight upward bias is useful too if the market maker is getting payed partially in another asset like with Uniswap– otherwise a mean reverting market is probably ideal. While tight ranges allow greater capital efficiency, any range offers profit potential. Volume is required.

Short term range trader or retail market maker: This trader needs the market to move “enough” inside a range to generate a profit. This can be the “quasi” style market making or other short-term styles. The trader cannot generate a profit from volume per say but instead profits from volatility and mean reversion. While volume and volatility are correlated, they are not identical. The capital efficiency problem is very difficult problem for retail style market making because without ability to capture spread profits: the trader needs to profit from movement. Range expansion is the big problem for traders that average into trades– and those rare moves that just cannot be bounded. Accounting for the rare moves means such a low leverage that the return goes down.

Swing trader: Swing traders typically need for markets to move in one direction strongly and make a reversal. This can be ascribed too as breaking a range and then reversing to trade back inside it. Swing traders spend a lot of time out of markets waiting for big moves.

Momentum trader: Momentum trader needs a strong move in one direction. Momentum traders profit from temporary to persistent range extension.

Trend trader: The trend trader wants a strong and sustained one-way directional move but can also profit from more choppy trends provided they are sustained. A very tight trend allows for more leverage and makes it easier to hold. The trend trader needs a sustained range extension.

What I find interesting is that no style does well in all conditions– if the market maker or liquidity provider is doing well then the trend trader is probably flat to negative. On the other hand, when markets trend strongly liquidity providers are unlikely to be doing well.

In trading, it is important to get to the “ground truth” of markets. Here we see that most styles profit from mean reversion or trending activity. One benefit that liquidity providing has is that traders earn profit from the spread and/or fees.

About the Author

The author is passionate about markets. He has developed top ranked futures strategies. His core focus is (1) applying machine learning and developing systematic strategies, and (2) solving the toughest problems of discretionary trading by applying quantitative tools, machine learning, and performance discipline. You can contact the author at curtis@beyondbacktesting.com.

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