Sebi allows market-making in illiquid equity derivatives

Sebi allows market-making in illiquid equity derivatives

Mumbai: In a key move aimed at deepening the Indian markets, capital market regulator Securities and Exchange Board of India (Sebi) on Thursday allowed market-making in illiquid equity derivatives.

The guidelines for “enhancing liquidity" in illiquid derivatives have been welcomed by brokers as well as the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).

“We believe that this would help to develop and deepen the derivative markets in India both in terms of depth and breadth," said Madhu Kannan, BSE managing director and chief executive officer.

BSE has been pushing for market-making to improve its flagging fortunes in the equity derivatives market, where NSE has a near monopoly with over 99% market share.

“We had been lobbying hard for this for the past seven-eight months and we are glad that the current Sebi administration has taken a progressive stance on this," said a senior BSE official, who didn’t want to be identified.

Stock exchanges have been allowed to design their own schemes to incentivize market-makers as long as they disclose the terms of such programmes. Exchanges can offer fee discounts, adjustments in fees in other segments, cash payments or even shareholding in the stock exchange to a market-maker.

Market-makers are brokers who take the risk of holding a certain number of shares with themselves to facilitate trading, in return for compensation.

They offer both buy and sell bids to other market participants.

Brokers say this is a first step to bringing Indian markets in line with global ones, where market-making is a common practice.

“Market-making in the derivatives segment has been a common feature in most markets. Leave alone Western markets, even in other Asian markets like Singapore and Hong Kong, market-makers play a big role in providing liquidity," said Yuvraj Sehgal, executive director (derivatives) at JP Morgan India Pvt. Ltd.

The move to allow exchanges to offer shareholding to market-makers up to 25% of issued capital is a bit unusual though, brokers said.

“While cash payments for market-makers in both cash and derivative segments are quite common across the globe, I do not see how offering equity stake is going to attract brokers unless you have a broker who is extremely loyal to a particular exchange," said Sandeep Singal, co-head (institutional equities) at Emkay Global Financial Services Ltd.

The BSE official cited above, however, maintained that there may be brokers who are large liquidity providers and interested in such an option.

The market-making scheme of the exchange has to be intimated to the market at least 15 days in advance, should be non-discretionary and the outcome of the scheme—the incentives granted as well as the volumes achieved—should be disseminated monthly.

This would ensure transparency in this scheme and should help prevent abuses of the system, an exchange official said.

Sebi has allowed market-making for futures and options in new listings or in securities where the average turnover is less than 0.1% of market capitalization and for all securities in case of a new exchange or segment.

This means if United Stock Exchange or MCX Stock Exchange Ltd were to get approval to start equity derivatives, they would be allowed to offer market-making schemes.

Both these exchanges as well as the two national stock exchanges have been consulted while framing the guidelines, Sebi said.

Such schemes would, however, be valid only for six months or till the average turnover reaches 1% of the market capitalization.

While welcoming Sebi’s initiative, Yogesh Radke, head of derivatives at Edelweiss Capital Ltd, pointed out that the success of this measure would depend on the kind of incentives that are offered as well as on the fundamentals of the shares whose derivatives are being traded.

“Although there are about 230 stock derivatives, liquidity is restricted to the top 100 scrips and such a move would help in driving up liquidity in some of the illiquid shares," he added.

Radke said that in derivatives where the underlying stock is extremely illiquid, it might be difficult to get market-makers as such stocks can be subject to high volatility in prices.

JP Morgan’s Sehgal, however, pointed out that in markets abroad, the usual practice for a market-maker is to hedge positions once one of the bids is accepted, so that the losses, if any, are minimized.

“If implemented well, this will bring another set of players into the market and if the market-making scheme is incentivized in a way that market-makers are assured that they won’t make losses, there could be a lot of takers for it," he added.

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