BSE introduces market making to improve liquidity
Isaac Pinielo | Friday July 24, 2015 14:45
Market making is described as the act of simultaneously submitting bid and offer prices into the Automated Trading System (ATS) with the intention of infusing liquidity in securities that are not frequently traded on the stock exchange.
BSE deputy chief executive officer, Thapelo Tsheole said the implementation of market making on the local exchange should entail the appointment of institutions that would have applied to be registered as market makers.
“Market makers’ role is to either inject or mop up excess liquidity into and/or out of the market for a particular designated security as and when needed,” he explained.
Market makers are banks and brokerages, which stand by all hours of the trading day, with a firm, ask and bid price on a stock.
Tsheole further said a market maker may be registered to make a market for a single designated security, or multiple designated securities subject to meeting the criteria set out in the market making rules. He also said the introduction of market making came after the realisation that the local bourse is characterised by low levels of liquidity hence poor price discovery for listed securities.
Price discovery is defined as the general process used in determining spot prices. These prices are dependent upon market conditions affecting supply and demand.
“Therefore, the market maker is expected to unlock liquidity, leading to better price discovery and an increase in the depth of the market,” Tsheole said.
He further noted that other benefits for introducing market making is to create ease entry and exit of investors, which will lead to, enhanced portfolio diversification, management and development of other sophisticated securities.
Tsheole revealed that a concept paper on market making was presented to and approved by the BSE Main Committee on March 23, 2015. He added that following this approval the drafting of the market making rules commenced and is currently at the stakeholder consultation stage.
He indicated that the concept has been introduced formally in other African markets such as the Nigerian Stock Exchange (NSE). Market makers also operate in other advanced markets such as the Johannesburg Securities Exchange (JSE), albeit not necessarily in a formalised or regulated manner.
A professional banker and investor, Ikanyeng Segonetso reiterated that securities in the local exchange are clouded by illiquidity, adding that one way of solving this problem, asynchronous trading and lack of price discovery, is to make use of market makers.
“Asynchronous trading is whereby investors come at different times in the market to buy or sell securities, a phenomenon that results in unmatched orders,” he said.
Segonetso also indicated that the bid-ask spread of securities is the cornerstone of market making.
“Say the bid-ask spread for Sefalana shares is P12.03 and P12.10. The market maker would then buy shares at P12.03 and offer to sell shares at P12.08. Since this is the best offer compared to P12.10, investors would likely buy the stock. This represents the market makers profit of P0.05 per share. Liquidity has been provided,” he said.
However, Segonetso noted that market makers could also make losses for stocks in which they make the markets. He said this happens when the stock price falls below the price at which the market maker bought it.
“From the above example, if Sefalana shares drops below P12.03 to P12.00, then the market maker would lose P0.03. Losses such as these are covered by the market makers’ fees and commission,” he said.
The banker also said the market maker continuously provide buy and sell quotes for stocks which does not have a market, noting that the BSE has set some limits on how these quotes can be given.
According to Segonetso, the buy or sell orders would be executed through the BSE approved brokers. He said the big players in the market making activities are the banks, adding that the regulatory environment, restrictions on capital as well as the liquidity squeeze would limit the participation of banks.
In January, the BSE released the final draft of the rules regulating market makers on the bourse, which shall come into force on approval by both the BSE Main Committee and the Non-Bank Financial Institutions Regulatory Authority (NBFIRA).
Market making simplified below:
BusinessWeek: What is a market maker?
Segonetso: In a normal trading day on the BSE, there are willing buyers and willing sellers of different stocks, where order flow is matched. Thus, for a transaction to occur there has to be an investor on the other side.
As an investor willing to buy shares, for example, if you want to buy 1,000 Choppies shares, you would normally approach your stockbroker to place an order for this transaction. The stockbroker would then go to the stock market (exchange) to find a willing seller (vice versa, if you placed a sell order).
It is very unlikely that the stockbroker will always find someone who is interested in buying or selling the exact number of shares of the same company at the exact same time (a phenomenon known as asynchronous trading). This begs the question, how is it that you can buy or sell anytime? This is where a market maker comes in.
A market maker is a bank or brokerage company that stands ready every second of the trading day with a firm ask and bid price (they quote buying and selling price of the stock they are making a market for). This is good for you, because when you place an order to sell your thousand shares of Choppies, the market maker will actually purchase the stock from you (because no one was willing to buy your shares), even if he does not have a seller lined up. In doing so, they are literally “making a market” for the stock. Effectively they buy the stock and keep it in their Central Securities Depository (CSDB) account in anticipation that a buyer would come in the near future.
BusinessWeek: How do market makers make their money?
Segonetso: Market makers are compensated for the risk they take; take a scenario where a market maker buys your shares in Choppies then the company’s stock price begins to fall before a willing buyer has purchased the shares, what will happen?
To prevent this, the market maker maintains a spread on each stock he covers. The maximum spread will be determined by the BSE with reference to the last traded price. Using the previous example, the market maker may purchase shares of Choppies from you for P4.93 each (the ask price) and then offer to sell them to a buyer at P4.95 (bid).
The difference between the ask and bid price, is only P0.02, but by trading millions of shares a day, he has managed to pocket a significant chunk of change to offset his risk. Other than making money from the bid ask spread, market makers make money from the fees they charge companies in which they make the market for.
Orders are executed through designated brokers, and unless the exchange determines otherwise, market makers are obligated to sell to retail investors only, but may buy from both retail and institutional investors.