Market Making System

The extensive reforms in the last decade have transformed the operations of the securities market. Transaction costs have reduced and transparency has increased with the introduction of electronic trading and order-matching system at all stock exchanges. However, there are still a large number of shares that are not actively traded despite the fact that many of them have some intrinsic value.

To provide liquidity scrips, market makers are required who will continuously provide two way quotes. A market maker puts up a buy quote and a sell quote simultaneously. Thus, he creates a market for a scrip wherein it can be easily bought and sold. This process is called market making mechanism. For rendering these services, the market maker is allowed to buy and sell at a different rate, with the differential rate ranging from 3 percent to 10 per cent. This difference is his for providing these services.

Market making was much in use during the floor based trading era when jobbers used to play the role of market makers. However, market making is almost absent in the screen based trading era. The major hindrances to its development are the non-availability of back finances to brokers, lack of incentives such as authority to route trades through market makers, and lack of market depth. The market making scheme has been introduced in the derivatives segment also where it has not yielded the expected results.

Internationally, the market making concept is highly advanced and a highly specialized job, with select firms specializing in it. The market making responsibility is taken up by firms who have specialized in this activity on the basis of the size of the companies and select industries Some market makers cater to particular regions of the country or purely to institutional clients. The market making activity is very active in the US markets, especially in NASDAQ. Among the top NASDAQ listed companies, Oracle has as many as 101 active market makers followed by Cisco systems with 99, Dell Computer with 90, Applied Materials with 88, Intel with 86 and Microsoft with 82 Moreover, Indian stocks such as Sify, with 13 market makers, are clocking on average daily volume of around 50,000 to 60,000 trades and Rediff with 9 market makers manages 4,000 to 5,000 trades. NASDAQ has around 4,730 companies listed, of which over 90 per cent manage to trade on any given day. This volume of trading is due to active market makers. Whereas on the Bombay Stock Exchange, out of 5,700 listed companies, hardly 1,500 manage to trade on a given day.

In India, systematic and organized firm of market was initiated by OTCEI. At OTCEI, market making is a compulsory activity and the sponsor has to act as a market maker for at least three years. At the regional stock exchanges some brokers tried two way quotes to revive some illiquid scrips, but they could not be successful.

To facilitate the market system on Indian stock exchanges SEBI set up a committee on market making to study various facets of market making, including the merits and demerits of the two trading systems – the order driven system and quote driven system. The committee was of the view that shares could be classified into two categories – liquid and illiquid and market making facility should be provided for illiquid shares. The committee stressed the obligation of market makers to offer continuous two way quotes which would force them to carry an inventory of stocks. However, this would require a large commitment of capital and lead to an increased exposure to market risks. It is expected that the stock lending scheme and margin trading would give impetus to market making.