Retainer vs Options Model for Market-Making

To answer the question,

“Are options in market-making deals predatory?”

We need to talk about car mechanics. When you take your car to the mechanic, the mechanic can charge you $100 or $10,000, but you can’t really validate what is wrong with your car. There is a lot of information asymmetry, so you often end up just paying what they ask. Market-makers may seem similar, because there is information asymmetry.

If the car mechanic is thinking about short time horizons and wants to make money quickly, they will behave in a predatory way. However, if they consider building their business over a long period of time, then will consider relationships and reputation. Ultimately, an options deal is just a structure, so it depends on the terms of the specific deal, as to whether it is predatory or not.

It is true that during the previous bull market in particular, certain market-makers would take a token loan that accounted for 4-5% of the entire circulation, with a very low strike price (sometimes even lower than the last round of funding), without KPI’s or SLA’s. In these cases, market-makers are taking advantage of asymmetric information, because projects may not understand the value of the options to begin with. Even in traditional finance, structured products are popular to sell to retail investors because they don’t know how to value them correctly.

Options Loan Model: Aligned Upside

In the options loan model, market-makers are provided with the flexibility to borrow and trade a predetermined number of tokens during the TGE. You should get a number of different proposals from market-makers and compare them. Most market-makers value their options on a Black-Scholes model. Usually, they are using American options, but there are also European and Bermuda options.

The things that will affect the pricing are:

1. Time Period: A longer time period gives more opportunity to hit the strike price. However, anything shorter than a year is not beneficial for anyone, since it takes time ramp up. In the same, it is not advised to switch MM’s often.
2. Loan Size: The larger the loan size, the more the options. The loan size depends on the total FDV of the token. The higher the FDV, the smaller the percentage. A USDT loan is often necessary as well, in case the market-maker needs to buy the token as they’re market-making.
3. Volatility: This is not explicitly stated in contract since neither party has control over, but in general higher volatility means the likelihood of hitting the strike price is higher.
4. Different Tranches: Different forward-starting strikes, e.g. tranche 1 starting now, tranche 2 starting 3 months from now. Projects don’t have a strong view of how much their project will go up, and so the we are unsure how fair the strike is to them. The first tranche is based on the price today, and then second tranche bases the strike price on the next date that set (quarterly or semi-annually). This way it protects the project from losing too much if the price goes up significantly.
5. Strike Price: A lower price will make it more likely the option comes into the money.

Depending on the market-makers risk appetite and their belief in the performance in the token, they will adjust the KPI’s for you. In this case, the market-maker takes all the trading risk and downside, which means they could lose value during certain short-term time span spikes.

With MM’s who have integrity, they are incentivised to perform optimally, as their compensation is often tied to the long-term success of the project’s token performance. This aligns our interests with yours, fostering a mutually beneficial relationship. However, if you work with a more dubious MM, their compensation being tied to the project’s long-term success may incentivise riskier strategies. You can ask the market-maker about their own propriety trading record, the number of traders and engineers they have, as this can be indicative how well they will actually be able to hit their KPI’s. While aligning interests is positive, excessive risk-taking could lead to undesirable consequences if not closely monitored.

The options loan model typically involves lower upfront costs for project founders. It allows you to conserve resources while still benefiting from market-making services. As the market-maker is good at managing and pricing risk, they are taking this responsibility. As the market evolves, the options loan model allows for adjustments to the strategy based on real-time market conditions. This adaptability is crucial for mitigating risks and optimising liquidity.

While the longer-term upside is more aligned, the greatest risk is that the market-maker will stop performing if they are out of the money with the strike price. However, contractually the market-maker is still obliged to hit their KPI’s regardless of the upside is still present.

Retainer Model: Fixed Costs

The retainer model, on the other hand, involves a fixed fee paid to market-makers for their services over a specified period. The pricing is typically a set fee per trading pair per exchange, with some discounts if there are more pairs. While this model may involve higher initial costs, it brings its own set of advantages. Essentially, rather than providing a loan of tokens to the MM, like in options, retainer MM’s allow you to use their low-latency trading infrastructure and leverage their algorithms. You use your own capital and keep ownership of the liquidity. This means they’re not taking on any trading risk.

The retainer model allows for better budgeting and financial planning, as costs are predetermined and fixed. This stability can be particularly reassuring for project founders aiming for a transparent financial outlook. Committing to a long-term retainer may create challenges if the market experiences unforeseen changes. The fixed nature of the retainer may limit the ability to adapt quickly to evolving market conditions, and even disincentivize the market-maker to perform better than they potentially could.

The usual reason that projects tend towards retainer models is because of risk aversion. There is no incentive for the MM to dump the token or make the price fluctuate — they only make money off the fee, regardless of performance of the token. However, this is mostly a concern for projects with lower than 100 million FDV.

If you take the more conservative position that tokens are securities, and that if they are not already regulated, they will be soon, then there might regulatory risk attached. Using securities law as an analogy, if you are a company that issues a stock, that governs how you can trade your own stock. Since essentially you’re trading your own tokens (analogous stock) this model may come under scrutiny.

Price List as of Jan 2024 of a Number of Retainer-based MM’s

• 7k for first exchange additional 1k for each additional+ 20% carry
• 4k for first exchange 2k for additional exchanges + 20% carry
• 3k for each exchange + 20% carry
• 1.5k for exchange capped at 10k for unlimited exchange + 20%
• 5k for first exchange 3k every additional + 20% carry
• 1.5k each exchange + 20% carry
• 3k each exchange + 20% carry
• 4k for each exchange + 20% carry
• 1k for each exchange + 15% carry

Pricing, as with all products is a loose proxy of quality. If a company is offering a service too cheaply, projects should be cautious about why this happening. 

Be Wary

If an MM promises a token price target or trading volume (aka wash trading), run for the hills. This is market manipulation, not market-making. This is basically really illegal outside of crypto.

Working with a MM you trust, is above all, the most important thing. Another way to build trust is to work with them in other ways, such as DMM, LP-ing, sequencers, or liquidators.

Market-making IS a Service

Either way, with market-makers, you are paying for a service. You are either paying a fixed amount or with your potential upside. If the MM is willing to sign an options deal with you, then that is them taking a bet that the price of your project will go up, and then want to be involved with that. If the MM would prefer a retainer deal, then they will have less risk and still continuously make money, regardless of the performance of your token.

It is important to negotiate and understand the KPI’s and SLA’s, and hold your MM to those numbers once you sign with them. Ultimately, token projects should weigh these positives and negatives against their specific goals, risk tolerance, and market conditions to determine the most suitable approach for their market making needs.

If you liked this piece, check out our four-part series on the Fundamentals of Market-Making
Talk to us about market making and listings  – services@caladan.xyz