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The history of pure derivative products in Pakistan is not very old; cash-settled stock futures were introduced last year, while stock index futures were introduced in the first quarter of 2008. Derivative products usually take 2 to 3 years to take off in a developing market like Pakistan; hence it is no surprise that there have been negligible volumes in both these derivative products since their inception.
In my view, the one basic reason for these products not taking off is the lack of natural liquidity in these markets. Natural liquidity is an extensive pool of investors who are aware of and have a potential interest in buying and/ or selling a security. For example, if an investor wanted to take a long position in a cash-settled futures contract, the investor might have a very long wait before the other side of the trade (an interest to sell) appeared from the public.
Moreover, any investor who succeeds in taking a position has no assurance that the market will be liquid enough in future to provide him exit, in case he chooses to square his position. These fears have kept the investors away from these derivative markets. The question comes to our mind that how can we make our derivative markets naturally liquid. The answer is: Market Makers. Why? Because market makers help markets operate continuously.
There are a number of factors which contribute towards liquidity in equity markets, such as free float, market access, internet trading, restriction on foreign currency flows, trading infrastructure, retail participation, conducive regulatory framework etc. In this reading, however, we will confine ourselves to the "role of market makers" in increasing liquidity in equity markets.
Before we discuss how market makers contribute towards increasing liquidity in markets, let us see what does liquidity mean in secondary equity markets, and how can it be measured.
Liquidity is typically understood as the market's ability to absorb large amount of trades without causing excessive price movements.In addition, liquid markets are characterised by narrow bid and ask spreads. This means that transactions are carried out in a cost effective manner.
LIQUID MARKET, AS DEFINED BY A KNOWN FINANCIAL SCHOLAR, IS ONE WHICH IS:
1. Tight - which means that costs of trading small amounts are themselves small (ie bid-ask spreads are small). As a result, investors can trade positions without excessive loss of value.
2. Deep - costs of trading large amounts are small too - big trades don't cause large price movements. Deep markets have high quoted depths, which is the number of shares available for purchase or sale at the quoted bid and ask prices.
3. Resilient - discrepancies between prices and "true" values for the asset in question are small and corrected very quickly.
Liquid markets should, therefore, facilitate entry and exit at minimal loss to nominal values, low transaction costs, and within a short time frame. People usually consider volumes in a security to measure liquidity in that security, which is technically incorrect. A liquid scrip is one in which there are large number of bids and offers at all times, with tight bid-ask spreads.
Theoretically speaking, it means that there can be a scenario on a given day that a security might have large number of willing buyers and sellers with tight spreads, but no trades executed, due to non-matching of bid and offer prices. Despite zero volume, this security will still be called liquid because there was a significant buying and selling interest in that security on that day.
"Impact cost" is a widely acceptable measure for indicating liquidity in a security, which measures the market impact of executing an order. A liquid scrip has lower impact cost as compared to an non-liquid scrip.
GENERALLY, SPEAKING, INTERMEDIARIES CAN ADD LIQUIDITY TO A MARKET IN THREE WAYS:
(a) as a dealer who uses its own capital to take proprietary positions in the market;
(b) as a Market Maker who uses its own capital to take proprietary positions but who has obligations to provide liquidity, usually getting certain benefits in return; and (c) as a specialist who provides liquidity to the securities in which it specialises. Like the market-maker he commits capital to provide liquidity where there is order imbalance; however, his intervention is not continuous. While market-makers are usually competing with one another, the specialist has a monopoly for the stocks in respect of which he is appointed.
The need of intermediaries to provide liquidity is a much debated topic. Some say that automatic order-matching is sufficient, others say that intermediaries are needed to bridge gaps between supply and demand.
Some studies suggest that the appropriate market structure depends on the type of securities to be traded, as that influences the supply and demand characteristics of the securities. For example, small capitalised stocks are often thinly traded. An intermediary can bridge the gap to ensure that transactions occur within reasonable amounts of time and without large price changes.
"Market makers" are participants in quote-driven financial instrument trading environments that fulfil the function of generating bids and offers. They create liquid markets by consistently quoting (buying and selling prices) -- thereby ensuring the existence of a two-way market.
In other words, they are required to use their own capital to make a market in a stock by buying and selling from their own inventory, when public orders to buy or sell the stock are absent. Market liquidity is likely to be asymmetrical in that it is high in a bull market, but may be very thin in a bear market, or the majority of market participants may all favour buying or selling at the same time.
Market makers need to be financially sound with sufficiently large capital resources. This is particularly the case in developing markets, where the asymmetry is acute and potentially severe. Market making may consequently be costly during a bear run, because market makers will often have to buy large quantities of securities during this phase. In order to encourage market makers to continue to provide liquidity in difficult times, exchanges normally grant them certain privileges.
The present equity markets in Pakistan are order-driven automated markets, with no role of market makers in Regular and Derivative segments; however, concept of market making does exist in the OTC Market. Unfortunately, no company has ever listed on our OTC Market, which was established in 2005.
Some one might question that if the market maker model is so useful in providing liquidity, why did it fail in Pakistan in the case of OTC Market. Before I answer this question, let us first see what an OTC Market is, and why the market maker model is so widely used for such markets. In order to attract small companies to go public, most countries provide an OTC Market, which serves as a junior exchange to the main exchange.
Smaller companies prefer to list on OTC Market, to take benefit of various incentives. Market makers are designated for companies which list on the OTC Market to provide liquidity. In the absence of market makers for these small stocks, they will not get regular order flows, and the resulting demand-supply imbalances will often render their prices very volatile.
The Rules of OTC Market at Karachi Stock Exchange have been laid down under the Regulations governing Over the Counter (OTC) Market, 2005. A high-level review of this regulatory framework reveals that the design of OTC Market lacks in the following areas:
1. It forced market makers to provide liquidity cheaply against their best judgement of risks. The Regulations governing OTC Market of KSE require the market makers to operate in price bands of 2.5% upward or downward, which are very low considering the risk of companies in which they are making market.
2. Despite certain relaxations in respect of Corporate Governance requirements presently available to OTC companies, the regulatory framework needs to be made more flexible, such as by giving additional relaxations in requirements which are normally applicable to companies listed on the Regular Market.
3. No incentives were provided to market makers in the form of revenue sharing arrangements with the exchange, exemption from exchange laga and SECP fee etc.
4. No tax incentives were provided to investors in the OTC Market, such as taxation of dividends and capital gains at lower rates.
THE ABOVE ISSUES NEED TO BE ADDRESSED, IN ORDER TO MAKE OUR OTC MARKET:
-- more viable for potential market participants to act as market makers, and
-- lucrative for smaller companies to join the OTC Market, which presently attract very thin volumes in the Regular Market
Now, we come to the issue of implementing market maker model in our derivative markets, so that natural liquidity is available in these markets. The following aspects should be considered before a market maker model is put in place for the derivative markets:
1. Setting capital requirements that are not so onerous that they prevent intermediaries from taking positions and making markets;
2. Setting licensing requirements that do not unnecessarily strain scarce capital and managerial resources;
3. Allowing spreads that commercially compensate market makers for their risk taking;
4. Providing incentives to the market makers. These incentives may be in the form of fixed remuneration or revenue sharing arrangement with the exchange. Moreover, market makers may be offered exclusivity in the sense that all orders must flow through Market Makers where that security is subject to market making;
5. Providing various trade execution advantages, such as priority over competing orders, where marking making and continuous auction systems co-exist for a security (also called a hybrid system);
6. Providing various exemptions from risk management regime, for example non-applicability of position limits; and;
7. No restrictions on short selling under any circumstances
The advantage of the market-making mechanism is that it is designed to assure liquidity. However, this liquidity comes at a price. The market-maker has to maintain a wide enough spread to cover the cost of his capital and provide him with a profit.
Some contend that the higher costs result from collusion among market makers; others that it is simply the legitimate price for obtaining liquidity. Some observers also argue that the order execution process with market maker systems is less transparent, raising greater possibility for unfair practices such as front-running.
Since market-making has a significant cost, intermediaries are generally more interested in making markets in larger more active stocks - ie, stocks that are already more liquid. In less liquid stocks, market-makers are generally less willing to commit resources.
Thus - from the point of view of liquidity -there is the risk that market-makers will be there when not needed, and not there when needed. The challenge which lies ahead for the apex and front-line regulators of equity market is to develop a market-making model, which encourages those with adequate finances to step forward and fulfil the role of market [email protected].

Copyright Business Recorder, 2008

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