There are two sides to every coin, and likewise, there are two sides to every trade. The obvious two sides to each transaction are — a buyer and a seller. But in capital markets, there is also the party that provides liquidity — the one who is quoting a bid or ask; and the party that ‘hits’ the bid or ask. The party quoting and providing liquidity is referred to as a market maker, and the party “hitting” the bid/ask is the market taker.
Out of sight Often, traders are barely aware that there is a party continuously quoting on the other side. At 9:15 am, traders, many a times, do not realise the complexity of what is going on “behind the scenes” to create all that liquidity. How is it possible for a counter party to be present always on the side of the trade? An exchange’s biggest hurdle is to get buyers and sellers on its exchange versus other exchanges.
This is especially true for exchanges lagging behind others in terms of turnover done, and is even more pressing for an exchange looking to begin operations.
For an exchange fully operational, its market makers do not need incentives through rebates. This is because there is so much activity that sellers looking to offset large amount of positions will automatically provide ample liquidity on the selling side (asks). This is because they know that since the exchange is known to be liquid with enough trades on a daily basis, this exchange becomes the preferred choice. The same applies to buy side firms looking to build up a large position; it can opt to pick off asks from the sell side market makers, or simply go in and provide it large position size on the bids.
Swift reaction Market makers are often the quickest to react to price movement. Even if it is a big institutional firm looking to sell off a large position, it will push prices up when there is large buy side demand.
Often, in exchanges around the world, market makers are rewarded for providing liquidity, and India is no different. On the NSE, it provides rebates to registered market makers on segments that have not picked up in volumes. This includes Equity ETFs and SME scripts, on which the market makers need to meet certain criteria to benefit from rebate incentives.
This includes providing ‘presence’, that is, to be actively quoting, for a minimum required amount of the trading day, and sometimes to also ensure that enough quantity is being provided within a prescribed minimum spread amount between the tightest bid and ask (bid-ask spread). The BSE also has an incentive programme for market makers, that is the Liquidity Enhancement Incentive Programmes (LEIPs).
Market makers have been always been around; it is only now that they are coming into focus. After all, when there is demand, a supplier always comes to the rescue. The capital markets are no different.
The writer is Cofounder, RKSV