This episode uncovers the shadowy mechanics of crypto market making, revealing how token launch deals can be structured to either provide stability or engineer catastrophic price manipulation.
Introduction to Crypto Market Making
- Market Making Defined: Matt explains that market making is the act of simultaneously providing a "bid" (a price to buy) and an "offer" (a price to sell) for an asset. This creates a market, allowing traders to execute large orders with minimal price impact.
- Core Function: The goal is to provide deep liquidity around the "mid-price" (the midpoint between the best bid and offer), which benefits the entire ecosystem by enabling smoother and more predictable trading. Matt emphasizes that this fundamental job is the same in both crypto and traditional finance (TradFi).
The Unique Challenges of Crypto Markets
- Extreme Volatility: Crypto tokens, especially in their first year, exhibit volatility that is 2x to 10x greater than traditional equities. Matt notes, "If you were to annualize that, that's around 400-500% of annualized volatility, that's crazy."
- Strong Trend-Following Nature: Unlike TradFi assets that are often "mean-reverting" (prices tend to return to an average), crypto assets follow strong, sustained trends. A token can go straight up (like Solana) or straight down. This poses a huge risk for market makers, who could end up continuously selling into a rally and accumulating a massive, dangerous short position.
The Call Option Model: A Crypto-Native Incentive Structure
- The Structure: A project's foundation lends a large number of its native tokens to the market maker. At the end of the term (typically one year), the market maker can either return the tokens or a pre-agreed-upon amount of US dollars.
- The Call Option: This repayment flexibility effectively creates a call option. The pre-agreed price at which the market maker can buy the tokens from the foundation is the strike price. This protects the market maker from a token that skyrockets, as they can always buy back the tokens they sold at the low, pre-determined strike price.
- Strategic Implication: This structure aligns incentives during a bull run. The foundation is happy because its treasury is worth more, and it doesn't mind the market maker profiting from the option, as it's a sign of the token's success.
How Benign Structures Turn Toxic
- The "Magnet Effect": If the token loan is too large relative to the circulating supply, the option's strike price can act like a magnet. The market maker is incentivized to sell whenever the price rises above the strike and buy whenever it falls below, effectively trapping the price and preventing healthy discovery.
- The Incentive to Dump: If a market maker holds a large loan and believes the token's price will fall, they are heavily incentivized to sell the tokens from the loan rather than shorting perpetuals. This is because selling spot is free of funding costs and liquidation risk, allowing them to dump supply onto the market and profit from the decline.
The Retainer Model: A Deceptive Alternative
- How It Works: The project pays a monthly cash retainer (e.g., $10k-$15k per exchange) for liquidity services. Crucially, the project provides tokens not as a loan, but as a deposit.
- The Hidden Risk: A deposit means the market maker returns whatever is left in the account at the end of the term. If they incur trading losses, the project bears 100% of that loss. Matt notes that firms specializing in this model have a business that "cannot lose money."
- Performance Failure: During high volatility—precisely when liquidity is needed most—retainer-based market makers often pull their orders because the small monthly fee doesn't justify the risk of massive trading losses. This leaves the project unprotected during major market moves.
"Active Market Making": Engineering a Pump and Dump
- The Playbook:
- Raise Cash: An "active market maker" convinces a project to sell a large amount of locked tokens (undeliverable for months) at a steep discount (up to 80%) to hedge funds and other buyers. This provides the project with immediate cash.
- Pump the Price: They use this cash to aggressively buy the token on the spot market, engineering a massive price rally on low circulating supply.
- The Inevitable Collapse: The hedge funds who bought the locked tokens see the rally stall. To lock in profits, they begin aggressively shorting perpetual contracts (perps—derivatives that track the token's price). This mass shorting causes the funding rate (payments between long and short traders) to plummet and triggers a cascade of selling, collapsing the price long before the locked tokens are even released.
- Matt's Analysis: "This is not so much pump and dump. This is really not normal market making... This is active market making by spot selling the future and really by and large toxic structure that cannot end well."
Prevalence and The Shifting Landscape
- Absurdly Prevalent: Matt states that these "active market making" pitches are "absurdly prevalent," with the vast majority of his clients having been approached. He attributes the rise to a more permissive regulatory atmosphere where founders feel they can get away with more.
- Diminishing Returns: The strategy is failing more quickly. Where it once might have worked for months, the window is now just a few weeks. Liquid funds, having been burned, now demand much deeper discounts (70-80%), making the economics of the scheme unsustainable for projects.
Accountability: The Role of Founders and Exchanges
- Founders: Matt is unequivocal: the buck stops with the founders who agree to these toxic deals, regardless of the rationale.
- Exchanges: While exchanges don't want to see tokens go to zero (it creates customer service nightmares), they are heavily incentivized by launch-day chaos. Matt reveals that a major exchange can make $10-20 million in a few days from a single, volatile token launch, giving them no reason to promote orderly price discovery.
The Core Problem: Broken Price Discovery
- Who Sets the Price? The initial price is not set by VCs, the team, or even market makers (who stay out of the initial chaotic minutes). It is set by "that crazy buyer who's buying at market, any size, any price." This creates an irrational, unsustainable peak that serves as a permanent, disappointing benchmark.
- A TradFi Solution: In traditional IPOs, an underwriter establishes a price, and a green shoe option allows the bank to issue more shares if demand is too high (calming volatility) or buy back shares if the price falls (providing support).
A Path Forward: The "Green Shoe" for Crypto
- The Strategy:
- Anchor the Price: Conduct a pre-launch sale close to the listing date to establish a reasonable, data-backed initial price.
- Implement a Green Shoe: Use a smart contract that automatically sells tokens if the price rises above the launch price and uses the proceeds to buy back tokens if the price falls below it.
- Strategic Insight: Matt argues that launching at a lower, more defensible valuation is a winning strategy. It sets the stage for sustainable growth and avoids the credibility-destroying "down only" chart that follows an overhyped launch.
Coinwatch's Role in a Complex Market
- Advisory: Coinwatch negotiates market making deals on behalf of projects, ensuring fair terms, clear liquidity targets, and exit clauses.
- Accountability via Tech: They developed Coinwatch Track, a platform that connects directly to market maker APIs. This allows projects to monitor their market makers' performance in real-time, verifying volume, depth, and spreads trustlessly from the exchange.
A Case Study: The Fraught Launch of Solana
- The Incident: Shortly after Solana's launch on Binance, the community discovered a large, undisclosed token transfer to its market maker. The backlash was so intense that Binance issued a public ultimatum: fix the situation or face consequences.
- The Standoff: The market maker had already sold a portion of the tokens to hedge their option's delta—a standard risk management practice. This created an intense, high-stakes negotiation behind the scenes, highlighting the immense pressure exchanges can exert on new projects.
Conclusion
This episode reveals that market making deals are a primary driver of a token's lifecycle and stability. Investors and researchers must scrutinize these opaque agreements and launch mechanics, as they are the key determinant of whether a project is built for sustainable growth or engineered for a catastrophic collapse.
