The Concept of "Market Makers"

[Apache]

Guys,
I ran accross this article on Proshare and it's quite interesting. I am pasting it below but i would like our more enlightened SMN members to share their view on this

"As one of the Nigerians in the Diaspora with some knowledge of the dynamics of the Capital Markets. I am regularly asked what types of investment instruments are available to them in Nigeria. My advice is usually to invest in the stock market. However, majority of them have expressed concerns about not being able to buy or sell their stocks when the need arises.

On January 15, 2007, I wrote an article about Cadbury Nigeria Plc shares being on a rebound on the Proshare website. At the time the article was published, the stock was trading at N35.58, and heading higher. Although the NSE daily tapes indicated that an average daily volume of about five hundred thousand shares traded, several investors who read the article and wanted to buy the shares were unable to do so, because of the unavailability of the shares in the open market. Pursuant to my discussion with a broker as to why investors were unable to find Cadbury shares, I was informed that most of the reflected daily volume trades were “cross trades” and not exchange trades. I was also reminded that investors encountered the same unavailability problems last year when they tried to buy the shares of BCC at N15, after the company made some pertinent pronouncements.

Cross trade is a practice where buy and sell orders for the same stock are offset without recording the trade on the exchange. This occurs when a brokerage firm executes both a buy and a sell order for the same security from one client’s account to another where both accounts are managed by the same portfolio manager. For example, an investor who has an account with brokerage house A wants to sell 1000 shares of Cadbury, the 1000 shares are sold to another investor who has an account with the same brokerage firm without giving an opportunity to investors registered with other brokerage firms to participate in the bidding process to buy or sell the shares.

In most developed markets, cross trades are seen as a way for brokers to rip off investors. When trades are not passed through the exchange, there is a good chance that an investor did not get the best price. In most developed exchanges, cross trades have been outlawed. Although cross trades have its advantages, there are also several disadvantages. For the individual buying shares through a cross trade, they may pay less brokers commission and might avoid some of the stringent NSE fees, because the shares are not exchange traded. However, cross trades leave room for stock price manipulation. Stocks trading in the NSE need to be democratized to enable knowledgeable investors execute certain trades directly without using a broker as an intermediary. I am by no means advocating the extinction of floor brokers and brokerage firms. However, I believe it is time for the NSE to gradually introduce the types of stock trading system practiced in most developed stock exchanges. For example, there should be “Market Makers” who are available to buy or sell shares to investors whenever there is the need.

Who is a Market Maker?

A Market Maker is a bank or brokerage company that stands ready every second of the trading day with a firm bid or ask price for each stock. This is good for investors, because when an investor places an order to sell 1,000 shares of Cadbury for example, the Market Maker will actually purchase the stock from them, even if the Market Maker does not have a seller lined up. Doing this is literally "making a market" for the stock.

Whenever a stock is bought or sold, there must be someone on the other end of the transaction. If you want to buy 1,000 shares of Cadbury, you must find a willing seller, and visa versa. It is very unlikely that you are always going to find someone who is interested in buying or selling the exact number of shares of the same company at the exact same time. How then can investors buy and sell stocks at any given time?, this is where a Market Maker comes in.

How do Market Makers make their Money?

Market Makers must be compensated for the risk they take in buying shares from investors when there are no actual buyers or investors willing to buy the shares of a specific company. To prevent the market maker from literally holding the bag as the saying goes, he or she will need to maintain a spread on each stock purchased. Using our Cadbury shares as an example, if the market maker purchased Cadbury shares from an investor at N33 each (the ask price), the market maker may probably offer the same shares for sale to another investor at N34 (bid). The difference between the ask and bid price of N1 translate to a significant chunk of cash for the market maker considering the fact that he is trading millions of shares each day.

Conclusion

It is imperative for the NSE to introduce the “Market Maker” system, to remove the notion that investors are unable to buy or sell shares on demand, or that the prices of shares are being manipulated by brokerage firms. Additionally, the market maker system will ascertain that investors who want to purchase the shares of specific companies will find the shares as opposed to brokers telling investors that shares of a particular company are not available for purchase.

[DaInvestor]

yeah read dat article though dont really understand the concept or how it works. is it that we will have special companies that perform this fuction or any tom dick and ali can just wake up and make himself a market maker, who regulates the purchase and sell prices cos the article talks about margin and thats where the profit comes from, are there regulations and legislation to support this or are we just going to make the laws if so the in a decades time i guess it will become reality cos our law makers are not concerned about this like that. considering the Nigerian environment can it really work even with laid down laws going by the antics of brokers, registrers, issuing houses and even the banks. not being skeptical but i really need an insight into the concept and the guildlines in those markets and how it is applicable to the nigerian environment.

[edwardaigbokhan]

Your write up on market maker in the NSE is very intelligent and interesting. though you made a great point regarding the responsibilities of the Market Makers. I believe the introduction of the agent would help to reduce the game some brokers places because there are instances of some brokers keeping your money with the excuse of non availability of a particular stock and since there are no other people to talk with they always gets away.

[crtide]

I think introducing market makers at this time will be a mistake because it will introduce another level of bureaucracy and avenue for the "big boys" to further manipulate the market. We have to be careful what we advocate for introduction into the market because we have to look at the peculiarity of our country and market and adapt or evolve solutions or processes that will take into considerations these peculiarities.

Just because a car that runs on diesel does more miles per litre than one that runs on petrol does not mean that the next time you go to the filling station you should fill your car that is designed to run on petrol with diesel. You need to modify your engine or adopt a new one in order to get the benefit of diesel otherwise you mess up your car.

I think at this time it is more imperative to improve and perfect the processes that we have in place, like issuing electronic certificates/allotment so that the issues of certificates being delayed or lost in the post is eliminated. This also partly deals with the issue of delays in certificate verification before sales. I mean my certificate is delayed or lost in the post, it takes forever for it to be verified after I eventually get it, how can the shares be available for sale.

Let everybody who wants to trade on the exchange or buy shares mandatorily open a cscs account with a broker if it’s their first time and subsequently include the cscs account details in every application filled for a PO. If you already have one just fill it out in the form. You can have multiple accounts with multiple brokers just like you do with banks. Just like everybody who wishes to put their money in a bank has an account to run the money from. But unlike a bank account, it does not go dormant if you do not touch it for years.

That way, we can all kind of trade by ourselves (sort of) I can give instructions to my broker to credit a cscs account with a certain amount of a certain share once I have agreed with that individual, if I do not find anyone I can agree with personally, I tell my broker to sell for me on the exchange.
I know this is happening at the moment but the % is just too minute and quite a lot of people do not have electronic shares account.

The good thing about it is that once your shares hit your account, it is in a saleable form, no need for re-verification that allows the big boys to hold one to ransom while they clean out.
It should be mandatory that everybody has an electronic account.

Also the issue of regulation should be taken seriously, the easiest part of regulation is making or drafting the laws, the most important is enforcing the law. The only reason people comply with laws is if there is a consequence to breaking it and not because the law exists. I am sorry to use a foreign example but it’s the only one that comes to mind at this time. For example in the UK, there are bus lanes in some major cities, these lanes are clearly marked and as the name says its only meant for commuter busses alone, no matter how much traffic there is on the read, you will not see any unauthorised cars on the lane, why? Not because Brits are more law abiding, but because there are bus lane cameras that will capture you on the lane and you are automatically issued and sent a fine.

In our situation, we have the legislation that stipulates that you must clearly outline the PO process from start to finish but I doubt that we have ways of enforcing it otherwise why would my money still be sitting with 1st bank or the issuing house months after the IPO. Remember, I wanted to invest it and the prospectus clearly states when I should get my money back if I am not allotted the number of shares that I applied for. Now, when I was investing my money, I looked at the risks enumerated in the prospectus and I was comfortable with it, that is why I invested, now irrespective of where I got the money from if I put it in a savings account for the period of time that its been with 1st bank or the issuing house, it will bear interest. Now is it fair that
1) I lose the projected income from being fully allotted the subscribed number of shares
2) I lose income by my investible money sitting in some account that I have no control of
3) The I do not get compensated or at least the interest borne by my returned money until such time as I draw it from whatever account it has been sitting
Now unless it’s a special account that does not add to the bottom line of the bank or organisation that owns it, then some people or organisation will benefit from retaining the money in the account unduly, now ladies and gentlemen, what will stop 2nd Bank, 3rd Bank and Nth bank or issuing house from doing the same to other people. Certainly not to me because I think I am too clever to be swindled this way again.

In the case where the regulators can not enforce legislation, then the legislation is as good as non existent.

[DaInvestor]

well said crtide my point exactly, nigerians are fond of the habit of looking abraod and just bringing changes without really taking a good look at the terain in which they want it implemened, the market is growing and should not be compared to the one abroad, dats not to say we should not aspire to be like them or even beta even though they stearted b4 us but the only way to go about that is to put checks and balances in place not to make the same mistakes they made and at the same time look for ways of catching up with them abnd then surpassing them.

this can only be achieved by good governance, ciommitment by everybody, change of attitude and most importantlty enforcing the law which most nigerians including myself still dont see as a mandatory responsibility, until then we will not see improvement in our process no matter what model we follow from anywhere in the world.

like the last speaker said i think the immediate challenge now, is to try and manage the progress we have made for now, have a stable market, punish offenders swiftly without sentiments, enforce the rule of law and the look forward with the nigerian terrain in mind before talking about new and advanced ideas.

this can first be started in ensuring the fraudulent brokers are reported, investigated and punished, issuing houses, the implementation of electronic everything i.e certs, bonus, trades etc, improve the education and create awareness about the industry to investors so they know their rights and thereby cannot be cheated, simple things like removing moribond companies from the daily list as in lets start from there before we talk about market makers. who are these market makers?? from the article they are banks or brokers. why do we want them??? to provent the same banks and brokers from cheating investors. so why should they act differently from the way they have been acting b4???? i dont know, so it beats me... but like i said b4 im not in the position to criticize what i dont know much about but from mere common sense is the angle in which im making my views/ personal opinions, its the first time im even hearing the word but i dont think we are ready 4 dat now

so dont lets create another problem that would set us back and allow these people to further exploit innocent nigerian just because its whats happening abroad, lets look at ways of improving our system after analysing it with the nigerian environment in mind.....

hope ive not said too much and looking forward to being educated more on these market makers so i can change my views/ position but 4 now this is where i stand

[hispy99]

Originally Posted by DaInvestor

well said crtide my point exactly, nigerians are fond of the habit of looking abraod and just bringing changes without really taking a good look at the terain in which they want it implemened, the market is growing and should not be compared to the one abroad, dats not to say we should not aspire to be like them or even beta even though they stearted b4 us but the only way to go about that is to put checks and balances in place not to make the same mistakes they made and at the same time look for ways of catching up with them abnd then surpassing them.

this can only be achieved by good governance, ciommitment by everybody, change of attitude and most importantlty enforcing the law which most nigerians including myself still dont see as a mandatory responsibility, until then we will not see improvement in our process no matter what model we follow from anywhere in the world.

like the last speaker said i think the immediate challenge now, is to try and manage the progress we have made for now, have a stable market, punish offenders swiftly without sentiments, enforce the rule of law and the look forward with the nigerian terrain in mind before talking about new and advanced ideas.

this can first be started in ensuring the fraudulent brokers are reported, investigated and punished, issuing houses, the implementation of electronic everything i.e certs, bonus, trades etc, improve the education and create awareness about the industry to investors so they know their rights and thereby cannot be cheated, simple things like removing moribond companies from the daily list as in lets start from there before we talk about market makers. who are these market makers?? from the article they are banks or brokers. why do we want them??? to provent the same banks and brokers from cheating investors. so why should they act differently from the way they have been acting b4???? i dont know, so it beats me... but like i said b4 im not in the position to criticize what i dont know much about but from mere common sense is the angle in which im making my views/ personal opinions, its the first time im even hearing the word but i dont think we are ready 4 dat now

so dont lets create another problem that would set us back and allow these people to further exploit innocent nigerian just because its whats happening abroad, lets look at ways of improving our system after analysing it with the nigerian environment in mind.....

hope ive not said too much and looking forward to being educated more on these market makers so i can change my views/ position but 4 now this is where i stand

Most developed markets that have market makers do not have restrictions on stock price (+/-5% currently for the NSE). I don't know how market making is possible when a stock cannot immediately reflect its true and fair value due to the limit put on price movement. For example, Enron fell by 23% in one day in 2001 and there are several stocks that have seen larger one declines in the U.S. If I am a market maker in Nigeria and Enron is only allowed to fall by 5% the day it declined by 23%, who am I going to sell the stock to? It is obvious that a lot of people will dump there stock to the market maker.

[pumping]

Originally Posted by hispy99

Most developed markets that have market makers do not have restrictions on stock price (+/-5% currently for the NSE). I don't know how market making is possible when a stock cannot immediately reflect its true and fair value due to the limit put on price movement. For example, Enron fell by 23% in one day in 2001 and there are several stocks that have seen larger one declines in the U.S. If I am a market maker in Nigeria and Enron is only allowed to fall by 5% the day it declined by 23%, who am I going to sell the stock to? It is obvious that a lot of people will dump there stock to the market maker.

This is the main crux of the matter. For this to work, the restriction of 5% rise or decrease of price per day must be removed. If I am a market maker and I know a stock is still worth another 20% of it's price today, why should I sell?

[olusolakemmy]

the introduction of market makers will simply give the big boys undue advantage in the market, infact in nigeria every system can be manipulated to favour the rich.

No need to try to counter the possible manipulation from the introduction of such, it should not just be introduce at all, cause in nigeria, NO LAW IS OBEYED, The rich understand that and are always ready to use it at any time T