Prerequisite: basic familiarity with what a prediction market is
So you want to run a prediction market. You need a way for people to trade shares. What are your options?
CLOBs and Markets
If you were making a prediction market from scratch, you'd probably come up with a Central Limit Order Book (CLOB). Traders post BUY and SELL orders, stating what they're willing to buy and sell, and at what price, and you record these orders in your book.
* Alice posts: "I'll buy 20 YES shares at $0.60 each"
* Bob posts: "I'll sell 25 YES shares at $0.65 each"
* Carol posts: "I'll buy 10 YES shares at $0.61 each"
When someone wants to trade, and doesn't want to wait for someone to fulfill their order, you match them with the best available offer. Pretty intuitive.
This system shows up directly in Hypixel Skyblock and other MMOs. The Bazaar lets you post orders and wait, or instantly fulfill existing orders. Have some Enchanted Iron to sell? You can list it at 540 coins and wait for a buyer, or instantly sell it by fulfilling the highest buy order at 470 coins.
The gap between the highest buy order ("bid") and the lowest sell order ("ask") is called the bid-ask spread.
Enter the Market Maker
CLOBs work well, but they have a problem: they need people actively posting orders from both sides. If nobody's posting orders, the market can't function. The spread can also become very wide when few traders are active, making it expensive to trade.
This is where market makers come in. A market maker continuously posts both buy and sell orders, ensuring there's always someone to trade with.
Market makers profit by maintaining a gap in prices between their bid and asks. For example:
* They buy YES shares at $0.60
* Sell YES shares at $0.65
* Whenever one person buys YES from them and another person sells it to them, they pocket the $0.05 difference
This is called crossing the spread. The market maker provides liquidity to the market and is compensated for it through the spre