What Is Market Making—and Why It Works in Crypto

Market making is the practice of continuously posting limit buy and sell orders to earn the spread and potentially maker rebates. Instead of paying taker fees by crossing the spread, you quote prices and let the market come to you. If structured well, the strategy earns via three components: captured spread, net rebates or fee discounts, and inventory P&L (which you aim to keep near zero over time). Crypto’s 24/7 trading, frequent micro‑volatility bursts, and fragmented liquidity make spread capture viable for disciplined traders who understand execution and risk.

CEX vs. DEX Market Making

• CEX (order‑book) market making: You place limit orders at chosen price levels, manage queue position, refresh when undercut, and dynamically adjust spread and size based on volatility and inventory.
• DEX (AMM/CLMM) liquidity provision: You supply token pairs to a pool and earn trading fees. Concentrated Liquidity Market Makers (CLMMs) let you choose a price range; your capital stays active within that range, similar to setting a band around mid‑price. You must handle impermanent loss and often hedge on a CEX if targeting delta‑neutrality.

Both paths are valid. CEXs offer tighter control of quotes and inventory; DEXs can reduce operational complexity but introduce impermanent loss and on‑chain costs. Many Canadian traders start on a domestic, registered CEX with CAD pairs and then explore DEX strategies once they’re comfortable with risk controls.

A Canadian Context: Platforms, Rules, and Taxes

In Canada, crypto trading platforms serving retail users are expected to be registered or operating under recognized frameworks. Trading on a registered Canadian crypto exchange (for example, platforms offering BTC/CAD or ETH/CAD books) helps ensure investor protections and compliance practices like segregated custody, KYC, and disclosure requirements. When you withdraw or deposit, know that FINTRAC rules influence how platforms monitor transactions for anti‑money‑laundering purposes, and the Travel Rule affects how certain transfers are recorded and shared between entities. As a user, your experience is typically frictionless—you’ll mostly notice standard KYC and occasional additional checks on large or unusual activity.

On taxes, the Canada Revenue Agency (CRA) treats crypto as a commodity for tax purposes. Whether your profits are considered business income or capital gains depends on your conduct: frequency, intention, level of organization, and whether you operate in a business‑like manner. Systematic market making with high turnover and detailed record‑keeping may tilt toward business income. Track everything: filled trades, fees, rebates, and any on‑chain gas or DEX pool fees. When in doubt, consult a Canadian tax professional familiar with crypto trading.

None of this is legal or tax advice. The key for retail market makers is to use compliant, registered venues for CAD on‑ramps and to keep meticulous records for CRA reporting.

Core Building Blocks of a Retail Market‑Making Strategy

1) Pair Selection

• Liquidity: Choose pairs with meaningful volume and depth. BTC/CAD and ETH/CAD are natural starters for Canadians; global traders can use BTC/USDT, ETH/USDT, or other top‑tier majors.
• Spread and tick size: You want spreads wide enough to cover fees and adverse selection, but not so wide that fill probability collapses. Observe average quoted spreads and how often the inside price shifts.
• Volatility: Higher volatility can boost spread capture but raises inventory risk. Start with majors and only graduate to alts once your process is robust.

2) Quoting the Spread

At the heart of market making is deciding where to place your bid and ask relative to the mid‑price. Two practical approaches:

• Volatility‑scaled bands: Set quotes at mid ± k × volatility, where volatility might be an ATR% or short‑horizon realized volatility. For example, if 1‑hour ATR is 0.8% and k = 0.35, your initial spread on each side is roughly 0.28% around mid (total spread ~0.56%).
• Inventory‑aware skew: Nudge your quotes to encourage reversion to your target inventory (often zero). If you’re long, tighten the ask and widen the bid slightly to reduce long exposure; if short, do the opposite.

A well‑known framework, useful even for retail, is the Avellaneda–Stoikov model. In simple terms, you set a reservation price (mid adjusted for current inventory and risk appetite) and then a symmetric or skewed spread around it based on volatility and your risk aversion. You don’t need advanced math to benefit from the idea: quote wider in fast markets, skew to unwind inventory, and narrow when conditions calm.

3) Order Size and Inventory Limits

• Sizing: Start small (for example, 0.5%–1.0% of account equity per side) and scale slowly. Thin books can expose oversized quotes to outsized adverse selection.
• Max inventory: Set a strict cap (e.g., 5%–10% of equity in net exposure). Use skew and occasional defensive taker orders to revert to neutral when you hit thresholds.
• Laddering: Place multiple levels at increasing distances from mid. The closest level aims for frequent fills; deeper levels capture mean reversion after abrupt moves.

4) Refresh and Queue Management

• Join or improve: If you’re behind in queue at the best bid/ask, decide whether to improve by one tick or rest and accept lower fill probability. Over‑improving erodes spread; never chase every tick.
• Quote life: Define a time‑in‑force. Cancel‑replace at a regular cadence or when mid moves beyond a threshold. Stale quotes are a common source of losses.
• Post‑only: Use post‑only or maker‑only order flags to avoid accidental taker fees when prices shift.

5) Volatility and News Filters

• ATR or realized vol gate: When short‑term volatility exceeds a threshold, widen your spread, reduce size, or temporarily pause quoting.
• Event controls: Major protocol upgrades, token unlocks, and macro data can change microstructure. Either hedge, widen dramatically, or stand aside during the high‑risk window.

Measuring Edge: What to Track

Edge is fragile unless you measure it. Focus on components you can control and optimize.

• Fill rate: Percentage of your quotes that trade. Too low suggests your spread is too wide or your queue position is weak.
• Markout (adverse selection): Average P&L of a fill after 5–60 seconds. If fills are followed by unfavorable moves, widen spreads or add filters.
• Realized spread: P&L after holding a short horizon, net of fees/rebates. It isolates how well your quotes perform relative to mid‑price changes.
• Inventory drift: How often and how far you deviate from target exposure. Persistent drift means your skew rules need tuning.
• Quote life and cancel ratio: Shorter quote life can reduce adverse selection but raises operational churn and potential throttling by the exchange.

Track daily and weekly performance: gross spread capture, total fees paid/earned, inventory P&L, and net P&L. A market‑making journal that captures parameter changes and outcomes accelerates learning and supports CRA reporting.

Execution Hygiene: Small Tweaks, Big Impact

• Maker‑only and post‑only flags: Prevent accidental taker fills.
• Good‑til‑time expiries: Auto‑retire stale quotes so you’re not being picked off by fast price moves.
• Iceberg/hidden orders: When supported, they help manage queue priority and reduce signaling.
• Self‑trade prevention (STP): Avoid wash trades and unexpected fees when you run multiple quotes.
• Cancel on disconnect: Ensure your open quotes don’t linger if your API session drops.
• Rate‑limit awareness: Respect exchange API quotas; batch updates to avoid throttling.
• Latency pragmatism: You don’t need co‑location to succeed as a retail trader. Robust parameters and filters often beat raw speed.

Risk Management: The Only Edge That Compounds

Market making can look smooth—until it doesn’t. Inventory shocks, thin weekend books, and sudden liquidations can erase weeks of gains. Build guardrails first.

• Daily loss limit: A kill switch that halts quoting if net P&L drops below a set threshold (e.g., −1.0% of equity).
• Inventory caps: Stop quoting on the side that increases your exposure when you hit limits; optionally take a small taker trade to neutralize.
• Volatility circuit breaker: If short‑horizon vol spikes beyond a cap, widen or step away.
• Pair suspension list: Disable quoting on illiquid or news‑driven tokens temporarily.
• Hedging rules: For DEX LPs, hedge deltas on a CEX if you aim for neutrality; predefine triggers.
• Custody and access: For Canadians, keep an operational float on a registered CEX for speed, while long‑term holdings sit in secure custody or a hardware wallet. Refill your float as needed.

Remember: if you scale to large, business‑like operations, you may trigger different tax or regulatory considerations. Trade on your own account, avoid soliciting others’ funds, and seek professional guidance before expanding.

CEX vs. DEX Liquidity: Choosing the Right Path

A practical progression for Canadian traders: begin with a registered CEX, learn quoting and inventory controls on BTC/CAD or ETH/CAD, then experiment with small DEX positions on majors where depth and volume are robust. Keep strategies separate and track performance independently.

A Simple, Rules‑Based Starter Template

Use this as a paper‑trading or tiny‑size prototype. Adjust parameters after you collect a statistically meaningful sample.

This template won’t win a latency race, but it does enforce discipline, which is where most retail edge lives. Over time, tune k, quote life, skew strength, and ladder spacing based on measured outcomes.

Worked Example: BTC/CAD with Volatility‑Scaled Quotes

Suppose BTC/CAD trades at 90,000 CAD with a 1‑hour ATR of 0.8%. Your base quote distance per side is 0.35 × 0.8% = 0.28%. The initial bid and ask would be approximately 90,000 × (1 ± 0.0028), or 89,748 and 90,252. If your inventory drifts long by 3% of equity, you tighten the ask by 0.06% and widen the bid by 0.06%—nudging fills toward flattening. If short‑horizon realized vol doubles versus its 1‑day median, you widen quotes to about 0.35% per side and reduce size by half. If losses reach −1.0% of equity on the day, your system disables new quotes and closes residual inventory methodically.

Track after‑fill markouts at 10, 30, and 60 seconds. If the average markout after a buy is notably negative, your bid is too aggressive; shift deeper or shorten quote life. If you rarely get filled, narrow slightly or improve queue position with a one‑tick nudge in calmer periods.

DEX Liquidity with Hedging: A Quick Comparison

On a CLMM‑style DEX, you could place a narrow range around the current price to emulate order‑book bands and earn fees. The trade‑off is impermanent loss if price trends strongly. A simple approach: provide a modest amount of liquidity in a tight band and hedge deltas on a CEX when price moves toward range edges. Your objectives mirror CEX market making—earn fees (the analog of spread) while keeping inventory risk contained.

For Canadians, consider gas costs, on‑chain execution delays, and operational security. Keep DEX liquidity size proportional to your comfort with wallets, key management, and on‑chain risk. Record all fees and rewards for CRA reporting.

Compliance and Operational Best Practices for Canadians

• Use registered platforms: For CAD funding, prefer Canadian platforms that operate under recognized oversight. This supports consumer protections and clear disclosures.
• KYC and record‑keeping: Expect identity verification and routine monitoring. Maintain your own ledger of trades, fees, and any rebates or rewards.
• FINTRAC awareness: Understand that platforms maintain AML controls and may request additional information for larger transactions or unusual activity.
• CRA reporting: Classify income properly, store histories of trades and payouts, and consider tax software or professional advice, especially if you operate at high frequency.
• Custody hygiene: Keep a working balance on exchange for active quoting; move longer‑term holdings to secure custody. Use strong authentication and withdrawal allow‑lists.

Common Pitfalls—and How to Avoid Them

• Chasing every tick: Over‑improving destroys spread. Define when you join and when you step back.
• Ignoring markouts: If fills systematically lose money seconds later, your quotes are too aggressive for current conditions.
• Letting inventory run: Without caps and skew rules, a trend can trap you. Treat inventory like a hot stove.
• Trading illiquid alts early on: Start with majors; widen and downsize if you experiment on thinner books.
• Forgetting fees and rebates: Maker rebates help, but don’t rely on them to bail out poor quoting. Always analyze net of costs.
• No kill switch: A single volatile session can negate weeks of gains. Install daily and weekly stops before you scale.

A 30‑Day Plan to Test and Iterate

Only scale after 4–6 weeks of consistent execution and verified edge. If conditions change—spreads compress, volatility drops—adapt or pause. A market maker’s best trade is often the one they don’t take.