Who are Market Makers?

Investors interested in investing in Exchange Traded Funds (ETFs) would have come across the term Market Maker. So what are Market Makers and why are they so crucial to the ETF ecosystem?

Market makers (MMs) are financial firms which provide liquidity to ETF by standing ready to buy and sell ETF units from investors. MMs allow investors to build or exit their ETF positions easily and also help to keep the ETF price in line with its fair value i.e. Net Asset Value (NAV). The combined benefit of this is that investors can buy or sell ETFs at a price that is close to the NAV.

Market Markers help in providing liquidity for ETF

Liquidity refers to the ease with which an investor can convert their asset to cash close to fair value and vice versa. Blue-chip stocks, G-Secs (government securities) etc. have high liquidity since it is easy for a seller to find a buyer at a given time. However, for some securities, finding buyers and sellers willing to trade with each other in large quantities at all times can be difficult. This is where the market makers step in. MMs are prepared to purchase or sell securities to investors in the requested amount. MMs stand ready to both buy and sell securities from investors in the desired quantity. In this way, MMs increase the ETF liquidity, with sellers having the comfort of being able to exit their holdings easily. Buyers benefit too, since they can quickly build a large position in the ETF.

Market Markers assist in price discovery of ETF

In addition to boosting liquidity for an ETF, MMs also help in an ETF to trade at a price closer to its fair value i.e. NAV. Let’s recall the market price of the ETF is determined by the immediate demand and supply conditions for the ETF in the market. These short-term fluctuations can drive the ETF price temporarily higher or lower than the NAV; that is the ETF may be trading at a premium and or discount respectively. MMs can lessen these fluctuations and cause the ETF to trade closer to the NAV. This is because MMs have the ability to create or redeem ETF units in large quantities with the AMC. For example, suppose the ETF is trading at a large premium, i.e., higher than NAV. This is an unfavourable scenario for a potential buyer of the ETF, as they will end up buying the ETF for more than the fair value. To bring the price closer to NAV, the MM may buy ETF units from the AMC, and sell these units on the market.

Provisions of SEBI’s circular on passive funds

As per SEBI’s May ’22 circular, commonly known as ‘Circular on Development of Passive Funds’, the minimum ticket size for which large investors can transact directly with the AMC was increased to Rs. 25 crores, from May 1, 2023 onwards. As a result, several large investors who were transacting directly with the AMC when the previous lower minimum amount was applicable, will now transact through the exchange. This will bring additional trading to the exchange and benefit investors through better liquidity and higher trading volumes, leading to even lower costs for investors.

The information contained in this document is for general purposes only and not an investment advice. Readers should seek professional advice before taking any investment related decisions.

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