Market-making and derivatives

Anup Menon

IT HAS been a year since derivatives, to be more specific, stock index futures, were introduced in India in the Bombay Stock Exchange and the National Stock Exchange.

July 2001 also saw the start of derivatives trading in individual securities.

Now, SEBI has also approved the introduction of single stock futures in 31 stocks (see accompanying table). While a host of derivative products keeps coming into the market, the question to be asked is if they have been successful in the first place.

Click here for Table

A look at the volumes in these markets indicates that in general the derivatives market has so far failed to live up to expectations. An inter-market comparison would indicate that market interest seems to be lower at the BSE than at the NSE.

Click here for Table

To remedy the situation and to try and improve activity in the derivatives segment, the BSE has decided to bring market-makers into the picture. The primary objective is to try and attract more business. However, the question remains if they will be successful at this? Going by past experience and the design of market products, one would think otherwise.

To understand the concept of market-making, it would be useful to understand the current screen-based trading system. The market system in place is the limit order book system. Here the quotations of every single seller and buyer are pitted against each other and matched by a computer system.

Hence, the buyers and sellers are brought together through the system, bypassing the market-maker. Though this works well for liquid and actively-traded stocks, it does not work well for illiquid stocks. This is where a market-maker comes into the picture.

A market-maker is typically a person or an institution `making `makes a market for the stock'. This means the market-maker provides both a sell and a buy quote for the scrips in which he/it is making a market. The spread, in the form of the bid-ask spread, is the profit for the trade.

For instance, if the market-maker gives a quote of, say, Rs 105/100, then essentially the profit is Rs 5. The market-maker will buy from the market at Rs 100 and sell for Rs 105. Technically, for illiquid stocks the spreads tend to be higher to compensate for the higher risk taken by the market-maker.

But it is also interesting to note that the market maker himself can give quotes under the limit order system. Therefore, the question is if an intermediary is needed or it is better to transact business directly. The market-maker's job is to ensure that he can at any time make a market for the stock, thus keeping the stock reasonably liquid. Having said this, the most important issue is who will be the market-maker?

In this case, the market-makers are most likely to be the brokers. The challenges they face when it comes to derivatives are enormous. In general, institutional investors are by far the most active players in the derivatives market. Other investors, such as mutual funds and high net worth individuals, are still not using the derivatives market.

A broker is in the business of market making to reap a profit. But he is constrained by the fact that as there are few players in the industry, the liquidity risk is much higher. To compensate for that, he has to increase the bid-ask spread which may not be attractive to large institutional investor.

Further, given the lower level of liquidity at the BSE, the pricing of the products may also not be very efficient. Under these conditions, it is very hard to visualise any broker taking on the role of a market maker. This is especially true as the cost of investing in these products forces small investors to keep their distance from this market.

Thus, the very idea of improving activity and liquidity by introducing market-makers may not be feasible. With SEBI approving the introduction of single-stock futures, the BSE can focus on that. Single-stock futures could attract more small investor interest which, in turn, may spark broker interest.