What are the main challenges faced by market makers in the cryptocurrency space?

Tom Lee Reveals Market Maker Woes: Unpacking the Crypto Crunch

Fundstrat’s Tom Lee has repeatedly flagged a growing pain point in digital assets: market makers are under stress, and liquidity is thinner than headline volumes suggest. For crypto traders, builders, and institutions, understanding this “crypto crunch” is essential to navigate spreads, slippage, and volatility in 2025.

What Lee’s Warning Means for Crypto Liquidity

Since the collapse of Alameda Research in late 2022, the crypto market’s liquidity fabric has been rewoven. Major high-frequency firms scaled back in 2023, and while new players and prime brokers have stepped in, the ecosystem remains less robust than during the last cycle. The 2024 launch of U.S. spot Bitcoin ETFs, followed by spot Ether ETFs later that year, added powerful new pipes for demand-but also new frictions in inventory warehousing, hedging, and settlement.

Lee’s broader point: when fewer dealers are willing or able to warehouse risk, order books get thinner, the cost of immediacy rises, and prices overreact to flows-both up and down.

Why Crypto Market Makers Are Under Pressure in 2025

1) Post-FTX pullback and liquidity concentration

• Alameda’s exit removed a large, always-on liquidity provider, leaving structural gaps that were never fully replaced.
• Several TradFi-aligned HFTs reduced U.S. crypto activity in 2023 amid regulatory uncertainty, concentrating depth on a smaller set of firms and venues.
• Derivatives depth shifted toward CME, which became a dominant venue for BTC futures open interest, reinforcing institutional but more basis-driven liquidity.

2) ETF plumbing created inventory and hedging frictions

• U.S. spot Bitcoin ETFs (approved January 2024) channeled large, lumpy inflows. Authorized participants and market makers must source or hedge inventory quickly, tightening borrow and widening basis during peak flow days.
• Spot Ether ETFs added a second leg of demand later in 2024. ETH’s more complex staking/funding dynamics can amplify hedging costs during stress.
• Result: spreads widen and market depth thins intraday around large ETF creations/redemptions and macro events.

3) Banking, capital, and compliance constraints

• Basel crypto rules (phasing in around 2025 in many jurisdictions) impose high risk weights on unbacked crypto, limiting bank-affiliated dealers’ balance sheet capacity.
• Prime broker rails improved (e.g., non-bank crypto primes and custodians), but rehypothecation limits, cross-margining frictions, and KYC/AML costs keep balance sheet dear.
• Stablecoin fragmentation persists; USDT remains the dominant dollar rail, while USDC adoption is stronger on U.S.-facing venues. Shifts in stablecoin liquidity can mechanically impact order book depth.

Signals of a Liquidity Crunch You Can Track

Traders can monitor a few high-signal metrics to anticipate slippage and volatility:

1. Top-of-book and 1-2% depth: Rapid drops in aggregated depth across major exchanges foreshadow outsized moves.
2. Spot-futures basis and funding rates: Persistent premiums signal inventory stress; sharp reversals warn of unwind risk.
3. ETF creation/redemption prints: Large net creations often precede basis widening; redemptions can pressure spot.
4. Stablecoin netflows and mint/burns: Dollar rail tightness often correlates with thinner liquidity.
5. CME vs. offshore OI share: A rising CME share can imply more hedged, macro-driven flow versus organic spot depth.

How The Crunch Shapes BTC, ETH, and the Long Tail

• BTC: More gap-like moves around ETF flow windows, CPI/Fed days, and large options expiries. Dealer hedging can exaggerate moves as gamma flips.
• ETH: Added complexity from staking yields, basis, and L2 flows. Spot ETF activity can tighten borrow and widen intraday spreads during demand spikes.
• Altcoins: Liquidity is highly path-dependent. Long-tail assets see step-function jumps in slippage; RFQ desks and DEX aggregators become essential for larger tickets.
• On-chain: DEX liquidity concentrates in a few pools; MEV and sandwich risk increase effective costs unless protected (e.g., RFQ, private orderflow, MEV-aware routers).

Practical Playbook for Traders and Builders

Traders

• Execution: Use TWAP/VWAP, iceberg, or RFQ for size. Avoid single-venue sweeps in thin books.
• Venue mix: Maintain connectivity to multiple CEXs, CME for hedges, and reputable OTC/RFQ desks.
• Risk: Monitor depth, funding, and ETF flows daily. Size positions to survive 2-3x normal slippage in stress.
• Collateral: Prefer high-quality custody and clear rehypothecation terms; diversify stablecoin exposure across trusted issuers.

Builders and protocols

• Liquidity design: Incentivize concentrated liquidity with guardrails; deploy circuit breakers to reduce toxic flow.
• Routing: Integrate RFQ and MEV-protected orderflow; support cross-chain liquidity via canonical bridges and audited intents.
• Data: Expose real-time depth, slippage estimates, and execution quality to users.

Conclusion

Tom Lee’s message is straightforward: crypto’s price action is increasingly flow-driven because the dealer layer is thinner and more constrained. ETF pipes brought mainstream demand but added stress to inventory and hedging. Until balance sheet capacity expands and regulatory clarity deepens, expect episodic liquidity air pockets. Traders who monitor depth and basis, diversify execution, and respect slippage risk will be best positioned to thrive in the current crypto market structure.