There’s two sides to every coin, and likewise, there’s two sides to every trade.
Of course, there’s the obvious two sides to each transaction- a buyer and a seller. But in the capital markets, there is also the party that provides the liquidity- that is, the one who is quoting a bid or ask; and then there is the party that “hits” the bid or ask. The party that is quoting and providing liquidity to the market is referred to as a Market Maker, and the party “hitting” the bid/ask is the Market Taker.
Often times traders are barely aware of the fact that there is a party continuously quoting on the other side. At 9:15, traders, many a times, do not realize the complexity of what is going on “behind the scenes” to create all that liquidity. How is it possible for a counter party to always be present on the side of the trade?
Market makers are critical in order to make a market function. In short, an exchange’s biggest hurdle is to get buyers and sellers to execute on its exchange versus other exchanges. This is especially true for exchanges that are lagging behind others in terms of turnover done, or even more pressing, for an exchange looking to begin its operations.
For an exchange that is already fully operational, its market makers do not need to be given incentives through rebates. This is because there is so much activity happening on the segment already that sellers looking to offset a large amount of positions will automatically provide ample liquidity on the selling side (asks), knowing that because the exchange is know to be liquid with enough trades going through it on a daily basis, the 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 it simply go in and provide it large position size on the bids.
And this, in essence, is how a market gets created.
Market makers are often the quickest to react to price movement. After all, even if it is a large institutional firm looking to get rid of a large position, it will push prices up when it notices that there is a large amount of buy side demand. By quoting higher prices, it generates better fills.
Often times in exchanges around the world, market makers are rewarded for providing liquidity to the markets, 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 ETF’s and SME scripts, on which the market makers need to meet certain criteria in order to benefit from the 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). In return, they receive incentives for turnover done and for satisfying the quoting criteria.
The BSE also has an incentive program for market makers through its LEIPS programmes.
Market makers have been around since the inception of stock exchanges; it is only now that they are really coming into focus. After all, when there is demand for a product, a supplier always comes to the rescue. The capital markets are no different.