What is market making and how it impacts liquidity - Motilal Oswal
What is market making and how it impacts liquidity - Motilal Oswal

What is market making and how it impacts liquidity

Among the various players in the stock market, the market maker is a very important link to providing liquidity to stocks. The exchanges have time and again experimented with this concept of having a full-fledged market maker to provide liquidity in stocks. While some are official market makers, there are others who provide liquidity as part of their business. Just as traders trade for profit, market makers help to make markets by giving liquidity and earning small spreads.

Let us understand what is market-making in trading and how the market maker and liquidity provider play an important role in the market. What is the market making strategy that is normally adopted and how does it help investors.

 

Why market makers play a key role in markets
The best way to understand market making is to understand a situation where there are no market makers. Imaging Stock X which is quoting in the market with the following bids

Buy QuantityBuy PriceSell QuantitySell Price1005202005241005155052620051350528250511150531400505200533

 

Any trader can see the risk that is evident in the above trading price mix. If you are buyer then the best price that you can buy is Rs.524. If you want to buy around 650 shares (assuming there are no hidden orders) you will have to buy up to Rs.533 that is Rs.9 off the mark. Similarly, if you are selling the stock then you can sell at the best price of Rs.520. And if you want to sell around 1000 shares then you will have to go almost Rs.15 down. Even for the lay investor it is quite obvious that there are two kinds of risks here. Firstly, the gap between the best buy and the best sell is Rs.4. In liquid stocks it is never more than 10-15 paisa. Similarly, the gap between subsequent ticks cannot be more than 5 paisa, whereas in this case it is too high. That is where market makers come in.

 

What role do market makers play here?
Market makers will give buy and sell quotes in such a way that the liquidity will automatically get created in the market. Let us look at the case of a liquid counter like Reliance Industries and see how the tick chart looks like.

 

Data Source: NSE

 

As can be seen in the above bid-ask table of RIL on 27th June 2018, the gap between the best buy price and the best sell price is just 10 paisa and the gap between two subsequent ticks is just 5 paisa. That is what reduces the risk in trading in such counters. So what is the role that the market maker play here?

 

The market maker is a key stock market participant and like any trader or arbitrageur, he is also there for the profit. So the market maker will typically give a buy quote at 976.30 and a sell quote at 976.70. This gap of 40 paisa is the spread on which the market maker will operate. Of course, there are additional transaction costs and you may wonder what spread the market maker will make? These market makers typically operate on volumes and not on margins. Since they do large volumes on a daily basis, they are able to earn. However, it is a risky job as there is no guarantee that both sides of your transactions will get executed. That is the risk that the market maker takes.

 

How market maker impacts liquidity

It is due to the presence of market makers that the volumes in a stock are created. Without the market makers, the stock will be highly illiquid and traders will not be too keen on trading it.

Effectively, these market makers make the market a lot safer and secure. Since they provide two way quotes, they reduce the basis risk and the trading risk for the market players. In the process, the market makers take the risk of market volatility and provide liquidity in the market.

In the past, exchanges have also come out with incentive schemes to market makers for creating liquidity in the markets. Initially, the BSE had tried that and later MCX-SX (now MSEI) had also tried the same. However, the results have not been encouraging since the volumes appear to be vanishing after the incentives are withdrawn.

Market makers also give a signal on the risk inherent in a stock. When market makers are not present in a stock, it is an indication that the stock is too risky and traders can position themselves accordingly.

In a nutshell, the market markets play a key role of supplying liquidity in the stock. In the process they operate on thin spreads. That is their reward.
 

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