Two-Sided Quoting Mechanism: How Bid/Ask Keeps the Market Running
The most basic task of a market maker is to simultaneously post buy prices (Bid) and sell prices (Ask) in the market, forming a price range where trades can consistently occur. When regular traders enter the market, whether they want to buy or sell immediately, they can quickly find a counterparty. This is the value of the two-sided quoting mechanism.
In a healthy market, market makers constantly adjust their quotes so prices move with the market. For example, when persistent buying occurs, market makers may gradually raise their bid and ask prices; when selling pressure increases, they lower quotes to avoid inventory risk.
This continuous quoting ensures price continuity in the market and prevents drastic gaps caused by a lack of counterparties.
Structurally, two-sided quoting brings several direct effects:
- Ensures there are always executable prices on the order book
- Shortens the time traders wait for counterparties
- Reduces short-term price volatility
- Enhances overall trading experience and market confidence
Therefore, Bid/Ask is not just two numbers. It is the foundational mechanism that keeps the market operating.
Spread Formation and Sources of Profit
The spread is one of the main sources of profit for market makers; it refers to the difference between bid and ask prices. In theory, market makers buy low and sell high, gradually accumulating profit through large volumes of trades. However, in reality, spread formation is far more complex than it appears.
Spread size is typically influenced by multiple factors, such as asset volatility, market depth, trading volume, and competition. In highly liquid mainstream pairs, fierce competition makes spreads very narrow; while for newly listed or low-volume assets, spreads are wider to compensate for higher risk.
For market makers, the spread is not only a source of profit but also a risk buffer. When market volatility increases, they often widen spreads to avoid losses during extreme moves; conversely, in stable conditions, spreads may narrow to boost trade execution rates.
Simply put, the spread essentially reflects a market maker’s pricing of risk and operational costs, it indicates how much the market demands liquidity.
Inventory Management and Risk Hedging Logic
Market makers don’t just match trades, they accumulate inventory (asset positions) during trading. If inventory remains biased in one direction (e.g., continuous buying without selling), they may suffer heavy losses if prices fall. Thus, inventory management is a core part of market-making strategies.
A typical inventory management approach usually includes:
- Dynamic quote adjustment: When inventory is high, raise ask prices to attract buyers; when inventory is low, raise bid prices to attract sellers.
- Cross-market hedging: Establish opposite positions on different exchanges or derivatives markets to reduce risks from price fluctuations.
- Asset allocation control: Limit holdings of any single asset to avoid concentrated risk.
- Automated algorithmic adjustments: Use quantitative models to monitor inventory changes in real time and automatically tweak strategies.
In the crypto market, some teams also use perpetual contracts or options for risk hedging to keep their overall exposure near neutral. This low-directionality, high-frequency trading style is a hallmark of modern market-making operations.
Differences Between Active and Passive Market-Making Strategies
Market-making strategies vary widely and are generally divided into active and passive approaches. Active market makers proactively participate in price movements by forecasting short-term trends, adjusting quotes, or even placing orders directly to increase profit opportunities. This style resembles quantitative trading and requires more complex models and faster execution.
In contrast, passive market-making focuses on steadily providing liquidity by consistently placing orders to earn spreads and trading rewards. For example, in DeFi liquidity mining, many LPs are essentially passive market makers. They don’t forecast trends but earn fees via pools.
The differences between these approaches are not only in profit sources but also in risk structure: active market-making carries higher directional risk but may yield greater returns; passive strategies have more dispersed risks but are prone to impermanent loss during one-sided markets. In practice, many professional teams combine both strategies and dynamically adjust their participation based on market conditions.
How Market Makers Behave Across Different Market Phases
Market maker behavior is not static, it changes significantly with market cycles. In early bull markets, as trading volume rises and sentiment improves, market makers usually increase order depth and narrow spreads to attract more trades. When markets surge rapidly, they may gradually reduce exposure to avoid accumulating too much inventory amid high volatility.
During sideways markets, market makers are often the most active participants, and price fluctuations within a range allow them to consistently earn spread profits. In extreme panic phases, some market makers may temporarily pull back quotes or reduce order sizes to limit potential losses. This explains why liquidity often suddenly disappears during sharp sell-offs.
In crypto markets, these behavioral shifts are even more pronounced. For instance, during major negative events or black swan incidents, algorithmic market makers may rapidly withdraw orders, thinning the order book instantly and amplifying price swings. Understanding how market makers behave at different stages helps traders gauge true liquidity conditions and identify potential risk signals.
