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Bitcoin Titan & Trading Titan
BITCOIN RELATED NEWS AND MARKET COMMENTARY.
Maximizing Liquidity Through the Make-or-Take Model
Bitcoin exchanges must adopt mainstream exchange fee schedules, which incentivize market makers, in order to substantially increase liquidity. In this paper I will propose a hypothetical bitcoin exchange, modestly called the “Super-Exchange”, that will increase liquidity for all trading between currencies, however, BTCUSD will be used throughout the paper as an example. In the context of the Super-Exchange, liquidity means bitcoins can be traded for other currencies without causing a significant movement in the BTCUSD price and with minimum loss of value.[1]
Unfortunately, all bitcoin exchanges currently use a flat percentage model, which does not promote liquidity. For example, Mt. Gox (Japanese based exchange), and CampBX (US based exchange) charge 0.6%[2] and 0.55%[3] respectively, for each transaction, to both the buyer and the seller. Under this model, especially with such high commissions, there is no incentive for market makers to participate.
Modern exchanges employ the “make-or-take” model to incentivize market makers to provide liquidity.[4] Under the make-or-take model market makers make money it two ways, 1) “trade across the bid-ask spread,” and 2) “earning liquidity rebates.”[5]
How market makers profit
The first way market makers generate revenue is to trade across the bid-ask spread by offering to buy a commodity or security at a certain price, and sell the same commodity or security at a higher price. For example, a market maker on the Super-Exchange exchange may offer to buy bitcoins at $4.90 USD, and sell bitcoins at $4.91. The market maker makes money by buying low to one trader and selling high to another trader many, many times throughout the day.
The second way market makers generate revenue is through liquidity rebates. Modern exchanges, like the NYSE, charge the “liquidity taker” a commission for every share bought or sold, typically three tenths of a penny. The exchange gives two tenths of a penny to the “liquidity maker,” called a liquidity rebate. The exchange keeps the last tenth of a penny as profit. Liquidity takers are traders that execute market orders against “resting limit orders.” Liquidity makers are market makers that submit “resting limit orders,”. A resting limit order is simply an order that is either an offer to buy below the current lowest ask price, or an order to sell above the current highest bid.
For example, on the NYSE, if the current highest bid for company C stock is $9.98, and the current lowest asking price is $10.01. The market making firm, “MM,” enters limit orders to buy and sell C’s stock for $9.99 and $10.00 respectively, narrowing the spread. If a liquidity taker, or “trader,” enters a market order to buy 50 shares of C from MM for $10.00, and another trader enters a market order to sell 50 shares of C to MM for $9.99, then MM will make $1 trading across the spread and $0.20 cents in liquidity rebates. As more market makers enter the exchange, the spread gets tighter and tighter because market makers must compete for volume. Furthermore, as the spread gets tighter, market makers generate substantially higher revenues through liquidity rebates rather than trading across the spread.
Under the make-or-take model, both market makers and traders benefit. In 2008, market makers made over $21 billion dollars.[6] In 2009, Jim Simmons and Ken Griffin (who both run liquidity-making hedge funds) personally took home $2.2 billion and $900 million, respectively.[7] Traders also benefit by having a stable exchange rate though tighter spreads that create insubstantial differences between trades, even with high volume transactions.
Applying Make-or-Take Model to Bitcoin Exchanges
The Super-Exchange must employ the make-or-take model between bitcoin and local currencies, because employing the make-or-take model will maximize liquidity and increase volume. Furthermore, the Super-Exchange will also increase revenue because an increase in liquidity also creates an increase in transaction frequency, which is when the Super-Exchange makes a profit. For example, the Super-Exchange charges the trader 0.0003 bitcoins per bitcoin bought or sold. The market maker receives 0.0002 bitcoins, and the Super-Exchange retains 0.0001 bitcoins as profit.
Note, the make-or-take model is only feasible because the Super-Exchange also holds the deposits of the market makers and traders. Under the example of the make-or-take model the commission is only 0.0003 bitcoins, whereas transactions across the bitcoin network, without an intermediary, are typically 0.01 bitcoins or higher. Thus, the commission to actually make the ownership transfer across the bitcoin network would be greater than the Super-Exchange’s commission, e.g., 0.0003 bitcoins.
Traders, or in this case depositors in the Super-Exchange, will enjoy tighter spreads and a much more liquid market with higher volume, rather than massive 1% jumps between two transactions executed seconds apart, often with a total transaction volume of less than 3 bitcoins.
[1]See Market Liquidity, Wikipedia,
http://en.wikipedia.org/wiki/Market_liquidity, as of April 3, 2012.
[2] Mt. Gox Fee Schedule,
https://mtgox.com/fee-schedule, as of April 6, 2012.
[3] CampBX FAQ,
https://campbx.com/faq.php, as of April 6, 2012.
[4]Regulating High Frequency Trading: An Examination of U.S. Equity Market Structure in Light of the May 6, 2010 Flash Crash, Stephen Barnes, available at
http://www.sec.gov/comments/s7-02-10/s70210-341.pdf, at 4; See SEC Concept Release on Equity Market Structure, 75 Fed. Reg. at 3607.
[5]Regulating High Frequency Trading: An Examination of U.S. Equity Market Structure in Light of the May 6, 2010 Flash Crash. at 5.
[6]Id. at 4.
[7]Id.
You can look up your "pofitable volatility range" on the spreadsheets.
It's the solution. 
