A few months ago, the Capital Markets Authority (CMA) said it was considering licensing a new class of market participants — broker-dealers — with a view of improving liquidity on the Nairobi Securities Exchange (NSE).
The idea is set on introducing market-makers for the stock and derivatives markets to ensure liquidity and raise price-determination efficiency. However, many are yet to understand the value and the role of these participants. Let's unpack this side of the market.
Who are market makers (also known as price-makers or price-givers)? These are market participants who quote both a buy and a sell price for financial instruments such as stocks and bonds.
They quote both sides of a price with the aim of making a profit by making the spread — the difference between their bid and offer prices. If the market remains steady, market makers hope to continually buy at the bid and sell at the offer. A market that relies on market makers for its price and order flow is known as a price/quote-driven market (different from an order-driven one).
The advantage of this type of market is the liquidity that the market makers provide since they are required to meet their quoted prices.
What system do we use at the NSE? What we have is an order-driven market where the order flow determines prices. It displays all the unfilled orders from both the buyers and sellers for each security, giving both the price and quantity of each security that is listed.
There is an order book, where higher bids and lower offers are ‘stacked’, so investors can see how ‘deep’ liquidity may be at various price levels. Typically, a deal is done when a buyer’s bid meets a seller’s offer. Do we need market makers? Yes, indeed. Liquidity at the NSE has been dismal. Turnover ratios have hovered around eight percent for years. And while this concern is most pronounced in the stock market, it also applies to other markets, including new derivatives markets and government bonds.
Secondly, important exchanges are now operating on an order-driven and matched bargain basis. In other words, liquidity is coming from both market makers and order-driven prices from customer orders. Lastly, market-makers facilitate market efficiency and functioning.
Moreover, with liquid markets, the hope is to facilitate the financing of investments and support economic growth.
Is the market-making system a sure bet? Not necessarily. If no changes in the general market environment occur and if the active investor base remains small and fragmented, then no amount of market-making activities will help.
Besides, if we adopt excessive liquidity regulation, then this may impede this crucial service.
All in all, supply of liquidity services by market-makers is essential to any well-functioning financial system and is an important element in the provision of market-based finance.
Overall, the idea is beneficial.
Mwanyasi is MD, Canaan Capital.
PAYE Tax Calculator
Note: The results are not exact but very close to the actual.
