Market-Makers and Liquidity
by andrew@JijiniMarkets - Mon 29 Jan 2007
Why is it almost impossible to buy or sell stocks at the exact prices posted daily by the NSE? The simple answer is liquidity; the price at which stocks are bought or sold is dependent on the availability of willing buyers and willing sellers at a given price and there simply aren't enough willing buyers or sellers -- at any price -- to meet these orders. This partly explains the massive price jumps of some stocks and the reason execution of trades usually takes days (if not weeks) to complete.
How is liquidity improved? Increasing the number of issued shares (e.g. through share splits) and the number of market participants (e.g. by encouraging greater public participation) helps. Both of these are geared towards increasing the chances that there will be sufficient buyers and sellers -- with sufficient number of shares -- to enable the matching of buy and sell orders. Another solution would be the availability of market-makers -- investment banks or brokers that are obliged to always post bid (buy) and offer (sell) prices for given securities as well as be willing buy or sell these securities at the prices they have posted. In most developed markets, one of the conditions for listing a company is the availability of two or more market-makers for the company's stock.
How do market-makers function? Money from market-making is made through spreads, i.e. the difference between the bid/offer prices posted. Unlike brokers who have very limited risks, market-makers take on two main types of risk: when buying stocks, there is the possibility that the value of the stocks may drop before they are sold; and most importantly in an illiquid market, there is the risk of not being able to source enough shares to meet demand. To mitigate against mis-pricing a stock (and potentially making heavy losses), they heavily research the stocks they cover and constantly monitor market conditions, regularly adjusting prices to match supply and demand; high demand and/or low supply of stocks will push prices up (to discourage buyers and entice sellers) while low demand and/or high supply will push prices down (to entice buyers and discourage sellers). As well as providing liquidity, market-makers therefore also ensure proper pricing of stocks.
The returns from market-making can be quite substantial especially during periods of high trading volumes. However, I suspect the reason it will take sometime to see voluntary market-makers on the NSE is down to lack of liquidity -- the inability to source shares during periods of high demand. Which is ironic as this is the exact problem they are meant to solve.
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