In the dynamic landscape of India's financial markets, liquidity – or the ease with which you can buy/sell securities without significantly affecting their price – serves as the foundation for efficient trading. Behind this smooth flow of transactions are entities known as market makers. But what is a market maker, and why is it essential for Indian investors to comprehend its role? Well, these entities play a pivotal role by consistently providing buy and sell quotes for securities, ensuring that investors can execute trades promptly without significant price fluctuations.
By bridging the gap between buyers and sellers, market makers contribute to market stability and foster investor confidence.
In this article, we’ll explore what market makers do, why they matter, how they operate, and what potential risks are involved in their activity.
Who are market makers?
A market maker is a firm or individual authorised to facilitate trading by continuously offering to both buy and sell a security. Market makers quote a buy price and a sell price for certain stocks or other assets at all times, thereby creating liquidity in the market. They are often member firms like brokerage companies that are appointed by stock exchanges to inject trading volume and potentially ensure there are always buyers and sellers for those securities.
Therefore, a market maker aims to bridge the gap between supply and demand. If an investor wants to sell shares and no other buyer is available, the market maker will purchase the shares from its own inventory to complete the order.
Conversely, if an investor wants to buy and no one is selling, the market maker sells shares from its holdings to the investor. For taking on the risk of holding inventory, the market maker earns a small profit through the spread between the buy and sell price on each trade.
Market making: A real-life example
Consider an investor looking to sell 500 shares of a relatively illiquid SME stock. In the absence of immediate buyers, the market maker steps in, purchasing the shares at the quoted bid price, say Rs. 100 per share. Subsequently, they offer these shares at a slightly higher ask price, perhaps Rs. 102, to potential buyers. The Rs. 2 difference per share represents the market maker's potential profit, compensating for the risk of holding the inventory.
Without a market maker, investors might struggle to find buyers or sellers, leading to price volatility and reduced liquidity. A market maker steps in by offering to buy and sell the stock at quoted prices, potentially ensuring that investors can execute trades promptly, thus stabilising the stock's price and enhancing liquidity.
Read Also: What is a Market Index?
Who serves as market makers?
Market makers are essential participants in India's financial markets, potentially ensuring liquidity and facilitating smooth trading. They are authorised entities that provide continuous buy and sell quotes for specific securities, enabling investors to execute trades promptly. In India, market makers operate under the regulatory framework established by the Securities and Exchange Board of India (SEBI).
Key participants acting as market makers
- Brokerage firms: Registered members of stock exchanges, brokerage firms often undertake market-making activities. They are instrumental in providing liquidity, especially in less-traded securities, by offering consistent bid and ask prices.
- Merchant bankers: Registered merchant bankers frequently act as market makers, particularly during initial public offerings (IPOs) of small and medium enterprises (SMEs). SEBI mandates their involvement to ensure adequate liquidity in newly listed securities.
- Financial institutions: Banks and non-banking financial companies (NBFCs) may serve as market makers in specific segments, such as rupee interest rate derivatives. Their participation seeks to enhance market depth and stability.
- High-frequency trading (HFT) firms: These firms utilise advanced algorithms and engage in strategies like momentum trading to quickly potentially capitalise on short-term price trends, thus enhancing market liquidity.
The importance of market makers
Market makers play a pivotal role in maintaining the efficiency and stability of financial markets.
Their contributions include:
- Continuous liquidity: By consistently providing buy and sell quotes, market makers aim to ensure that investors can enter or exit positions promptly, even in less-traded securities.
- Lower transaction costs: Market makers narrow the bid-ask spread, reducing the cost of trading for investors. This efficiency encourages higher trading volumes and market participation.
- Enhancing liquidity: They ensure that securities can be bought or sold promptly without causing significant price changes.
- Support for less-traded securities: Market makers provide liquidity for securities that may not have active trading, potentially ensuring that investors can transact without significant price changes.
- Reducing volatility: Their continuous presence in the market can help in stabilising prices, especially during periods of low trading activity.
- Facilitating price discovery: Through their activities, market makers aid in reflecting the true value of securities based on supply and demand dynamics.
By fulfilling these roles, market makers contribute to a more robust and accessible financial market, benefiting all participants.
Understanding the profit of market maker
Market makers earn profits through various mechanisms:
- Bid-ask spread: The primary source of potential income for market makers is the difference between the buying (bid) and selling (ask) prices. By purchasing securities at a lower price and selling them at a higher price, they can potentially capture the spread as profit.
- Incentives from exchanges: To encourage liquidity in specific securities, stock exchanges may offer incentives to market makers. These incentives can include reduced transaction fees or other financial benefits.
- Inventory appreciation: Market makers hold inventories of securities. If the value of these securities appreciates, they can realize additional potential profits upon selling.
However, it's essential to note that market making involves risks, including holding securities that may potentially depreciate or become illiquid.
Read Also: Types of trading in stock market
Conclusion
Market makers serve as the backbone of trading ecosystems. They seek to ensure that even less-traded securities can find a buyer or seller, potentially keeping markets efficient and investors’ confidence intact. For investors––whether you invest in SIP to potentially grow your mutual fund portfolio over the long run or participate in stock market trading––understanding the role of market makers can provide deeper insights into market dynamics and trading mechanisms. Market making is performed by regulated, well-capitalised firms, not something individual retail investors do, but knowing how it works can make you a more informed investor. In India, market makers operate under the guidelines set by the Securities and Exchange Board of India (SEBI), ensuring that their activities align with regulatory standards to maintain market integrity.
FAQs:
How do market makers help add liquidity?
Market makers continually quote buying and selling prices for securities to give investors immediate access to purchase or sell, limiting opportunities for price gaps during equity dips and enhances liquidity in the market.
How do market makers operate?
Market makers operate by utilising an approach that consists of inventory control, hedging strategies, and sophisticated algorithm trading. They monitor their levels of inventory and adjust to reduce exposure to price fluctuations. Market makers also use hedging instruments to potentially cushion against losses if price movements are adverse. Algorithmic trading allows for quick execution by market makers.
What are the risks associated with market making?
The main risk market makers face is the value of their inventory decreasing. If they purchase a stock and the price drops before they sell it then they have to absorb that potential loss. Potential setbacks may also accrue due to sudden volatility in the market if prices move faster than a market maker’s bids and asks. Technical glitches or slow reactions can cause potential losses as well.
Home
Contact Us
Login
Downloads
Schemes