Market Making Algorithm Revealed: Supporting the Market or Crashing It? How Market Makers Use Borrowed Coins

Author: @agintender
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Why should a token borrowed with strength be used to help you do business? What really happens behind the scenes after the project party hands over the tokens to the market makers? This article will unveil the core logic of algorithmic market making and analyze how market makers use your tokens to gain trading depth, price stability, and market confidence.

First, the conclusion: Due to the current lack of liquidity in altcoins, the optimal solution for market makers under the call option model is to sell the project party's tokens immediately after obtaining them. You might ask, if they sell the tokens right away, what if the token price goes up later? Wouldn't the market makers need a lot of money to buy them back?

Reasons:

1. The strategy of market makers is delta neutral; they do not take positions—what they want is to ensure profit without loss.

2. The call option has already capped the maximum price, limiting the market makers' risk exposure (even if the price surges 100 times, I can still buy at twice the price).

3. These types of market maker contracts are usually 12-24 months long. Given the number of projects currently in the market, most peak right after launch; how many can last until a year later?

4. Even if they survive 1-2 years, if the token price has skyrocketed, the profits from price fluctuations would be enough to cover the losses from the earlier "sell-off."

Introduction

Recently, the market has been performing well, and several friends around me have projects that want to TGE soon. They are currently stuck on the choice of "market makers." They all come to me with the terms from market makers, asking what I think of these conditions and what pitfalls there might be. What will market makers do with our tokens? Will they really provide liquidity?

Especially after seeing the report on Movement: https://cn.cointelegraph.com/news/movement-network-binance-38-million-buyback Disclaimer: The plot is purely fictional; any resemblance to actual events is coincidental. Argumentative disclaimer: If you think I am wrong, then you are right. Entertainment disclaimer: This article is written with the greatest "malice," not targeting anyone; just take a general look and enjoy.

1. Market Background

Generally speaking, the common cooperation models for market makers currently fall into three categories:

1. Renting market-making bots - The project party provides funds (tokens + stablecoins), and the market maker provides "technical" and "personnel" support, charging a retainer fee and/or a profit-sharing fee (if applicable).

2. Proactive market makers - The project party provides tokens (sometimes a bit of stablecoins), and the market maker provides funds (sometimes not providing stablecoins) for market making and community guidance, primarily aiming to sell tokens. After selling the tokens, the project party and market maker share the profits proportionally.

3. Call option (common) - The project party provides tokens, and the market maker provides funds (stablecoins), but the market maker has a call option; if the price exceeds the agreed price, the market maker can exercise the option to buy at a lower price.

This article mainly explains the most common model, 3. call option model.

2. Market Making Terms of the Call Option Model

From the perspective of a delta neutral market maker, the following project cooperation terms are generally offered (usually 12-24 months):

Note: Purely fictional; if it seems familiar, it’s just familiar.

CeFi Market Making Obligations

The market maker needs to provide liquidity for token ABC on the following exchanges:

Binance: Place buy and sell orders worth $100,000 each within a ±2% price range (i.e., you bear $100k USDT + $100k worth of ABC). Control the spread within 0.1%.

Bybit and Bitget: Similarly, provide buy and sell orders worth $50,000 each within a ±2% range (you need to invest $50k USDT + $50k worth of ABC), with the spread also controlled at 0.1%.

DeFi Market Making Obligations: You need to provide a liquidity pool of $1,000,000 for ABC on PancakeSwap, with 50% in USDT and 50% in ABC tokens (i.e., $500k USDT + $500k ABC).

Project Party Provides Resources: The project party will lend you 3 million ABC tokens (i.e., 2% of the total token supply, currently valued at $3M, meaning an FDV of $150M).

The current market price of ABC is $1/token.

The project party grants you option incentives (European call options): If the market price of ABC token rises in the future, you can choose to exercise the option to purchase tokens, with specific terms as follows:
Strike Price (Strike) | Quantity (ABC) | Exercise Conditions
$1.25 | 100,000 | If the market price > $1.25, you can buy at $1.25
$1.50 | 100,000 | If the market price > $1.50, you can buy at $1.50
$2.00 | 100,000 | If the market price > $2.00, you can buy at $2.00

If the market price does not reach the corresponding strike, you can choose not to exercise, incurring no obligations.

Based on the above conditions, as a market maker strictly following a delta-neutral strategy, how would you conduct overall market making and hedging arrangements after obtaining these 3 million ABC tokens to ensure you do not incur losses due to token price fluctuations?

3. Consideration: If You Were the Market Maker, What Would You Do?

3.1. Core Goals and Principles

Always maintain delta neutrality (this is the premise): The net position (spot + perpetual contracts + LP + option Delta) must always be close to zero to fully hedge against market price fluctuation risks.

Do not take directional risks: Profits should not depend on the rise or fall of ABC token prices.

Maximize non-directional profits: Profits come from four core channels:

a. Buy-sell spread on centralized exchanges (CEX).

b. Trading fees from liquidity pools (LP) on decentralized exchanges (DEX).

c. Volatility arbitrage (Gamma Scalping) achieved through hedging OTC options.

d. Potential favorable funding rates.

3.2. Initial Setup and Decisive First Step: Hedging

This is the most critical step in the entire strategy. Actions are determined not by price predictions but by the assets received and obligations undertaken.

3.2.1 Asset and Obligation Inventory

Assets received (also liabilities): 3,000,000 ABC tokens. This is a loan, and we are obligated to repay 3,000,000 ABC tokens in the future.

Obligation Deployment (Inventory and Funds):

Binance Market Making: 100,000 ABC (sell order) + 100,000 USDT (buy order)
Bybit/Bitget Market Making: 100,000 ABC (sell order) + 100,000 USDT (buy order)
PancakeSwap LP: 500,000 ABC + 500,000 USDT

Total Market Making Inventory: 700,000 ABC
Total USDT Required for Market Making: 700,000 USDT

3.2.2 Initial Net Exposure Calculation (Simple Calculation Version)

Note: The numbers are not important; the logic is more important.

If we only look at the token loan itself, holding 3 million ABC perfectly hedges the obligation to repay 3 million ABC. However, as a market maker, we cannot only look at the loan; we must consider the net position of the entire business.

USDT Funding Gap: Market making obligations require us to immediately put out at least 700,000 USDT to provide buy order liquidity. Where does this money come from? The most direct, protocol-compliant, and aligned with the current market's new coin peak opening method is to sell part of the borrowed ABC tokens to obtain it.

ABC that must be sold to obtain USDT: To obtain 700,000 USDT at the current price of $1, we must sell at least 700,000 ABC. (Generally, this will be done in the "initial liquidity window" or OTC; conscientious market makers will usually open a long position to hedge a bit.)

Recalculate net exposure: Initially, there are 3 million ABC.

Using 700,000 ABC as CEX and DEX sell order inventory.

At this point, the remaining ABC is: 3,000,000 - 700,000 (inventory) - 700,000 (sold for USDT) = 1,600,000 ABC. Now, this 1.6 million ABC is the true net long exposure (Net Long Delta). We no longer have a USDT funding gap, but the 1.6 million tokens we hold are unhedged; if the price drops, we will face losses.

3.2.3 Initial Hedging Operation: Answering "When to Sell?"

The answer is: Sell immediately. The amount sold is precisely calculated to achieve two goals: 1) Obtain the USDT needed for operations; 2) Hedge the remaining token exposure.

Action: At the very start of market making, our automated trading system will immediately sell a total of 2,300,000 ABC on the market. Of these, 700,000 ABC is to obtain the 700,000 USDT needed for market making. Additionally, 1,600,000 ABC is to hedge the remaining unhedged token position.

Why do this:

Meet operational needs: This provides us with the necessary dollar liquidity to fulfill all market making obligations. Achieve true delta neutrality: After selling all 2.3 million ABC, we no longer have any unhedged ABC token exposure. Our risk is completely neutral. Lock in risk: We completely transfer the risk of price fluctuations, focusing solely on profiting from market making and volatility.

We will not hold any "naked" ABC tokens waiting for the price to rise. Every token position, whether positive or negative, must be precisely hedged.

3.3. Dynamic Hedging: 24/7 Risk Management

After the initial hedging is completed, our risk exposure will continuously change due to market making activities and market fluctuations, requiring ongoing dynamic hedging.

CEX Market Making Hedging: When our buy orders are filled, we will buy ABC (creating long Delta), and the system will immediately short the equivalent amount of ABC in the perpetual contract market. The opposite is also true. We earn a 0.1% spread this way while maintaining delta neutrality.

DEX LP Hedging: The 500,000 ABC inventory in PancakeSwap carries the risk of impermanent loss, which is essentially a short Gamma position. Our model will continuously calculate the LP's Delta (negative when prices rise, positive when they fall) and hedge it with perpetual contracts.

3.4. Options Strategy: The True Profit Engine

This is the most intricate part of the entire trade and the key to surpassing simple market making and achieving excess profits.

3.4.1 Understanding the Value of Options

What we hold is not tokens but a right. This right (three-tier call options) has positive Delta and positive Gamma. This means:

Positive Delta: As prices rise, the value of the options increases.

Positive Gamma: The more volatile the price changes, the faster the Delta changes, which is more beneficial for us.

3.4.2 Hedge Options, Not Hold Tokens

We will not simply wait for the price to reach $1.25, $1.50, or $2.00. We will hedge the Delta of the options.

Initial Hedging: Use an option pricing model (like Black-Scholes) to calculate the total Delta of these three options at the current price of $1.00. Assume it calculates to +400,000. To maintain neutrality, we must additionally short 400,000 ABC in the perpetual contract market. (The larger the option, the more we need to short.)

Gamma Scalping: This is the dynamic answer to "when to buy and sell."

Scenario 1: Price rises from 1.00 to 1.10. The Delta of the options will increase (as it gets closer to the strike price), for example, from +400,000 to +550,000.

Our net position is no longer 0 but has a long exposure of +150,000. Action: Our system will automatically sell 150,000 ABC in perpetual contracts to re-establish neutrality.
Scenario 2: Price drops from 1.10 to 1.05. The Delta of the options will decrease, for example, from +550,000 to +500,000.

Our existing short hedge position becomes "over" and creates a net short exposure of -50,000. Action: Our system will automatically buy 50,000 ABC in perpetual contracts to cover, once again achieving neutrality.

Isn't it amazing?! Through hedging, we naturally achieve "sell high, buy low." This process repeats continuously, allowing us to "extract" profits from every market fluctuation; this is Gamma Scalping. We earn from volatility, not from direction.

3.4.3 Operations Near the Strike Price

When the price approaches and exceeds $1.25: Our first-tier option becomes in-the-money (ITM). Its Delta will quickly approach 1 (1 million).

Our short hedge position will also increase to nearly 1 million ABC. Exercise Decision: At the option expiration, if the price is above $1.25, we will exercise the option. Action: Pay $1,250,000 USDT to the project party to obtain 1,000,000 ABC tokens. Immediately sell these 1 million ABC tokens in the spot market. At the same time, close out the 1 million ABC perpetual contract short position established for hedging this option. Profit: The profit comes from the difference between the exercise price and the market price, as well as the accumulated gains from Gamma Scalping throughout the process.

The logic is exactly the same for exercise prices of $1.50 and $2.00. We are not betting on whether the price can reach; rather, we are continuously profiting by dynamically adjusting hedge positions during price fluctuations and executing risk-free exercise arbitrage when the price actually reaches.

3.5. Conclusion and Operational Recommendations

Initial Token Handling: Immediately sell 2.3 million ABC tokens, with 700,000 used to obtain operational USDT and 1.6 million to hedge the remaining positions. Never hold any unhedged token positions.

Price < $1.25: Do not actively buy or sell any non-hedged ABC. Continue CEX market making, DEX LP hedging, and options Gamma Scalping. Profits come from spreads, fees, and volatility.

Price > $1.25 (and subsequent exercise prices): When the price is significantly above the exercise price, our hedging engine has already established corresponding short positions for us. Exercising becomes a risk-free delivery process: buy tokens from the project party at a low price and immediately sell them at a high price in the market while closing out the hedge position.

This strategy breaks down a seemingly complex market-making agreement into a series of quantifiable, hedgeable, and profitable risk-neutral operations. The success of market makers does not rely on market predictions but on excellent risk management capabilities and technical execution.

After reading this, I hope you understand that it is not that market makers have issues with you, "deliberately" crashing the market; rather, under this mechanism and algorithm, selling tokens and opening short positions at the beginning is the locally optimal solution of the market-making strategy.

It is not that they are bad; it is a rational choice after weighing the pros and cons.

The market is cruel; the better a deal looks, the less risk it seems, often results from meticulous calculations.

When you cannot see the risk points, you are the risk point.

May we always maintain a heart of reverence for the market algorithms.