Partnered With:

Market making or dealing? Decrypting the 'secret transactions' between project parties and market makers.

Read this article in 17 Minutes

This article will discuss the specific mechanisms of token market makers and the potential for violations based on the recent Arbitrum incident.

Original Title: "Market Making or Dealing? Decrypting the "Secret Transactions" between Project Parties and Market Makers"

Original author: Alex

Translated by: TechFlow

The current digital asset market has developed into a huge global industry, attracting more and more investors and institutions to participate. However, as the market scope continues to expand and the number of market participants increases, market stability and fairness have become increasingly important issues.

Therefore, based on the recent Arbitrum incident, the author introduces the specific mechanism and potential violations of token market makers (MM), and puts forward personal opinions on the need for more disclosure in this field.

Why do current encryption projects all have market maker (MM) trading?

In the past, projects usually incentivized liquidity by providing tokens to the pool on-chain. However, now they provide incentives to complex market makers to provide liquidity on centralized exchanges (CEX).

This transformation is aimed at improving the efficiency of price discovery and reducing the costs of all parties involved.

On CEX, due to greater liquidity, price discovery is more effective. In addition, market makers are able to provide better buying and selling prices for buyers and sellers, making the market more attractive.

How to incentivize market makers in the encryption industry?

Usually, projects provide one-year token loans to market makers, with zero-cost subscription options attached to the tokens during the loan period. Specifically, the project will lend tokens to market makers (usually 3-5), and require market makers to guarantee market size and spreads during the loan period.

Why do projects need to lend coins to market makers?

Makers need token loans to ensure they have enough inventory to meet potential over-purchase demand in their operations.

Meanwhile, market makers need to conduct effective borrowing operations in order to offset excessive buyer demand when necessary.

Token loans typically have zero or very low interest rates. While market makers need tokens to provide liquidity, they do not want to incur significant borrowing costs.

Therefore, token lending is a common incentive mechanism that can provide necessary tokens to support market liquidity for market makers, while also reducing the cost burden for market makers.

Why give call options to market makers?

Market makers need to pay a cost to provide liquidity services. Project parties usually choose to use tokens instead of cash to pay for this cost because tokens are more liquid and operable.

However, in order to avoid market price fluctuations and protect the interests of investors caused by market makers immediately selling tokens, project parties usually give market makers subscription options to achieve incentive consistency. If the token price rises, market makers can earn more profits, and project parties can also benefit from the appreciation of the token.

If the token has not yet started trading, how to determine the exercise price of the call option?

In this case, the project party will choose to set the exercise price of the subscription option at a premium of 50% - 100% of the index price. Since the index price can usually be determined on-chain or in other markets, the exercise price does not need to be known at the time of the transaction.

This method of setting the exercise price of subscription options can provide a certain degree of flexibility for market makers and project parties, and can reduce trading risks. If the token price is higher than the exercise price, market makers can earn profit by realizing the price difference, and if the token price is lower than the exercise price, market makers can choose not to exercise the subscription option and give up the profit.

The mechanism of token market makers itself is not malicious. The problem is that these mechanisms usually do not disclose information to retail investors.

Therefore, this makes open market participants feel unfair. They may not be able to access important information about token prices and liquidity, resulting in losses in trading. If the project team or market maker clearly conveys this information to investors, the entire market can be more transparent and fair, thereby reducing investor losses and increasing market participants' confidence.

Let's take a look at the recent Arbitrum incident.

In the document, there is no mention of the terms and conditions of token market makers, which makes it difficult for investors to understand the actions and potential impact of market makers.

More importantly, the document does not explicitly state whether Wintermute (market maker) is an investor in Arbitrum, which could lead to conflicts of interest and moral risks.

When making investment decisions, retail investors based their analysis and decisions on the assumption that only 1.275 billion tokens mentioned in the document were the sole supply in the secondary market. However, this was not the case, leading to some unexpected situations.

1. Unknown Quantity of Call Options

These call options essentially increase the token's circulating supply, thereby affecting the token price and liquidity.

In order to maintain market neutrality, market makers need to hedge the Delta of subscription options by selling tokens. During this process, market makers sell a large number of tokens, which actually increases the supply of tokens, but this data is not disclosed to investors in a timely manner.

It is reported that Wintermute, a market maker, has added at least 16 million tokens to the secondary market through hedging trades, which is one of the reasons for the unstable token supply and price fluctuations.

2. OTC trading terms unknown

Another issue of interest is that the foundation sold tokens worth $10 million through an over-the-counter transaction with Wintermute (a market maker).

However, these actions were not disclosed to retail investors before the transaction occurred. In fact, investors did not learn of this information until after the transaction was completed.

At the same time, it was not mentioned in the original document whether the foundation has the right to sell tokens in such a short period of time.

3. The positioning of investors and market makers is unclear

In the Arbitrum incident, it is unclear whether Wintermute (a market maker) is an investor in the project.

Especially for retail investors, it is very important to understand the relationship between investors and market makers. They should have a clear understanding of the role and profit source of market makers in the market in order to correctly evaluate the risks and opportunities of the market.

Here is a famous strategy from Alameda:

Individual investors in this incident have suffered a double blow. Firstly, they were forced to accept additional tokens transferred to them without being notified.

Then, Arbitrum also attempted to secretly launch a false decentralized plan, but it was eventually exposed, leading to a drop in token prices.

The requirement for the prospectus to clearly outline the following in Tradfi's IPO is justified:

The number of issued shares;

The initial public offering price;

The underwriters participating in the transaction;

The profits and dividends obtained by underwriters.

These pieces of information are crucial for investors as they provide comprehensive and transparent details about the company and its stocks, helping investors make informed investment decisions.

Of course, there is also a reason related to insider trading laws. Participants who hold a large number of tokens or have access to insider information are required to publicly disclose their operations in the secondary market. This helps to protect the fairness and transparency of the market.

However, in the cryptocurrency market, there are sometimes non-compliant operations, such as the behavior of injecting a large number of tokens into the market. These operations usually have a negative impact on the market and cause harm to investors, which is unacceptable.

Transparency and fairness are very important for the development of the token market. The events of last week have caused significant damage to the industry, which also indicates that there are some shortcomings and loopholes in the existing rules and mechanisms.

In the current token market, many investors and traders are facing the problems of information asymmetry and market uncertainty. This situation not only affects the confidence and interests of investors, but may also hinder the development and innovation of the entire market.

Therefore, we need stricter regulation and more transparent market rules to promote market stability and reliability. Only by strengthening market transparency and fairness can we attract more investors and participants to join this industry.

I believe that we can establish a social contract together, requiring future projects to provide more transparent and open information and rules.

As investors and participants, we can take measures to achieve this goal. For example, not buying governance tokens that do not provide sufficient information and disclosure; or guarding the fairness and transparency of the market by conducting more research, investigation, and supervision.

At the same time, token issuers and market makers also need to take responsibility and provide more information and disclosure to meet the needs of investors and the market. Only through cooperation and joint efforts can the token market be made safer, fairer, and more reliable, thereby creating more opportunities and benefits for all market participants.