Investment in stock markets is subject to extreme volatility that can drive an investor’s portfolio either in the direction of gains or losses. In the face of such volatility, liquidity is the key to earning decent returns. ETFs are one of the prime securities that have liquidity as its key feature along with the benefits of diversification. However, there could be a case when the ETFs are not liquid enough as there are not enough buyers. This is when the market makers come into the picture.
Given below is a brief discussion about the meaning and the role of market makers in the relation to ETFs.
What are ETFs?
Before learning about the role of market makers with respect to ETFs, it is important to know the meaning of ETFs and their key features.
ETFs are exchange-traded funds that are essentially a pool of stocks selected based on the index that they track for their performance. ETFs are a passive investment product wherein the sole purpose of the fund is to track the performance of the index subject to tracking errors.
The key to a good ETF is low tracking error backed by a low expense ratio. This helps the investors maximize their gains and also get the benefit of diversification which is the essence of a mutual fund.
What is a market maker?
Market makers are the large banks and financial institutions that help in providing liquidity in the markets. Market makers are often appointed by the fund houses that launch ETFs to counter the liquidity issues. They are more commonly known as specialists, Designated Broker (DB), dealer, or Authorised persons (AP) in the market language.
Market makers help in providing liquidity by placing large or bulk orders and buying or selling securities.
How do market makers work?
Market makers are companies employed by stock exchanges or individual agents that operate in large numbers under the name of a common entity. As mentioned above, market makers buy and sell ETFs in bulk or in large volume orders to generate liquidity. When the market makers purchase or sell the ETFs they have to quote the prices for the same.
Market makers provide the ETF units for sale at the asking price on the recognized stock exchanges. Following this, they will post bid prices at which they will purchase the units focusing on the investors that require to sell their units. When the order is received by the market makers from the investor, the order is fulfilled by them. The gain for the market makers is the difference between the purchase price and the selling price and the commission or the fees charged by them for their services.
What are the types of market makers?
Market makers play an important role in maintaining the liquidity of ETFs in the market. There are three main categories of market makers and the details of the same are highlighted below.
a. Retail Market Makers
These are the retail brokerage firms that are employed to keep the ETF market liquid. They help in keeping the ETF prices more efficient and to keep the flow of the orders moving. The gains of the retail Market Makers are through the bid-ask spread as well as through the brokerage received by them even in case of commission-free trades.
These are the market makers that focus on the high-volume pools also known as dark pools. Wholesalers trade securities for both the retail market makers as well as institutional market makers. The orders are created based on high-frequency trading algorithms.
c. Institutional Market Makers
Institutional market makers are the largest market makers on the block and they work on large block orders for mutual funds. These market makers work for insurance companies, pension funds, and other asset management firms. The primary requirement for any institutional market maker is huge capital.
Market makers whether retail brokers or large entities like institutional market makers are roped in to maintain the liquidity in the ETF market. The ETF market in India is relatively new and although gaining momentum, does not have a huge investor base in comparison to regular stocks. This may create liquidity issues and may lead to potential losses if investors cannot exit the market on a timely basis. Hence, market markets are quite an essential part of the ETF markets.
Market makers make money through the bid-ask spread and through the brokerage they charge for every trade.
Market makers can lose money on account of extreme price fluctuations. For example, if the market maker has bought the security and the prices decline heavily, they can lose money quickly if they cannot sell their securities in time.
The key roles of the market makers include providing and maintaining the liquidity in the ETF market as well as ensuring that the units of the ETFs are traded at fair prices and are reflective of the prices of their underlying securities.
Yes. The key feature of ETFs is that they can be traded on stock exchanges like shares of listed companies.
No. ETFS belongs to passive funds and their performance is based on the performance of the index it tracks.