Stock market liquidity is the ability to execute large volumes of transactions without price disruption or volatility. A liquid market allows price discovery and fair valuation and allows investors to enter and exit positions with minimal hassle and reduced risk.
Liquid markets have:
– Width: bid / ask spreads which dictate the cost of reversing a position over a short period – the tighter the spread, the easier it is to enter and exit at a lower cost.
-Depth: the availability of several offers and offers that mitigate wild fluctuations resulting from large orders.
-Resistance: the ability to quickly recover from price fluctuations due to shocks.
Exchanges, regulators and capital market players can improve liquidity and efficiency of trade, which in turn will help attract more investment and spur economic growth.
To do this, GCC exchanges and regulators can focus on:
• Diversify the investor base by attracting local and international institutional investors through liberalization, the relaxation of regulatory barriers and the promotion of education and investor protection.
• Increase the pool of securities and financial products by expanding local listings, launching derivatives and ETFs and creating links with markets.
Liquidity is a victory for all
-For investors: reduced trading costs and the ability to buy and sell an asset quickly.
-For issuers: attractive entry into the market because the cost of raising capital is improving.
-For exchanges: better access to the market, investor confidence and the ability to attract new players.
-For savings: the ability of companies to raise funds increases local and foreign investments, increasing productivity and employment.
Importance of market making
A lot of work needs to be done before market making can effectively improve liquidity in the GCC markets. Proprietary market making has been in place in Bahrain – where SICO has been operating in this area since 1996 – long before it was regulated. Market making has evolved in the absence of hedging tools, with market operators such as SICO adopting a modified version in the form of liquidity delivery mechanisms.
A market maker commits its own capital to provide liquidity to a stock. The trader takes advantage of the bid / offer spreads of the investor’s trading activities. There is also another element of P&L due to stocks that the market maker maintains, which may rise or fall in value depending on stock prices.
GCC Markets introduced market making programs as part of their overhaul, which coincided with inclusion in major emerging indices. Widespread adoption has yet to pick up, but we expect momentum to improve once market players have had a chance to assess the positive results.
It is an agreement between an issuer and an operator acting as an agent to provide liquidity at arm’s length. This enables the adoption of a quote-driven marketplace, where multiple bids and offers are sent to the marketplace while maintaining minimal market presence throughout the day.
Regulations exist to govern the relationship between the issuer and the liquidity provider to ensure that the latter does not engage in price manipulation. Limits of 3 to 5% have been introduced on assets and the shares held are considered to be treasury shares on certain GCC markets, so they are not eligible for securities transactions such as dividends.
Why does the provision of liquidity not lead to an increase in stock prices?
The liquidity provision mandate and the related regulations clearly define the role of the liquidity provider. Engaging and offering deals and offers to increase market depth while minimizing price spreads will encourage investors to negotiate. The provider has full discretion over the portfolio, thus working independently and free from pressure from the issuer from the issuer. The regulations therefore clearly specify the role of the liquidity provider: to help price discovery without manipulating prices.
While deep liquidity provides room for price discovery and fair valuation, other factors such as investor appetite, financial condition and performance as well as the level of disclosure have a significant impact, in particular for long-term investors.
We believe that strong Investor Relations (IR) programs also support price discovery and work better. RI in the region has become important in helping investors understand businesses beyond financial reporting. Prospective investors need to better understand business roadmaps and strategies, creating a link between investors and management. The Bahrain Stock Exchange recently introduced its Guide to Best Practices in Investor Relations to help companies adopt best practices and highlight the importance of IRs. Research is also a great tool to help listed companies improve their IR campaigns and attract savvy investors who look beyond the numbers.
What better for the prices?
At the start of the market evolution cycle, we believe that liquidity provisions are best suited as a tool for creating and sustaining market depth. With the development of these markets and the introduction of hedging tools, market making programs will become a viable option for participants.
(The author is Director of Capital Markets at SICO)