Daily Independent (Lagos)
Kingsley Ighomwenghian
2 December 2008
opinion
News of the appointment of three operators by the Securities & Exchange Commission (SEC) last week did not immediately reflect on the market's indicators as some would have expected. The All-Share-Index finally achieved yet another 52-week low, the second since the last one, a few days earlier on November 5, 2008.
At the close of last week's trading, the index fell by a sharp 1,634.49 basis points or 4.71 per cent, closing at 33,025.75 points and bringing year-to-date slide in the nation's equity market to 43.05 per cent, while equities' capitalisation of the 213 quoted companies dropped N345.358 billion to close at N7.305 trillion. By the close of Monday's session, the index was at yet another 52-week low of 32,214.36 points, after First Bank, Guaranty Trust Bank, Intercontinental Bank and Access Bank and Guinness Nigeria contributed immensely to the fall, just as many stocks attained a new year-low. Analysts fear that the meltdown may linger till year end due to investor apathy and loss of confidence, which are being joined by the Islamic festive of Id-el-Maulud, Yuletide and the New Year known for the usual fees payments.
There were newspaper reports last week of the approval of the applications of Greenwich Trust Limited, Chapel Hill Advisory Limited and Diamond Capital & Financial Market Limited as market makers. Greenwich Trust is run by Mr. Kayode Falowo, Chapel Hill Denham, is the outfit managed by Mr. Bolaji Balogun, while Diamond Capital is a subsidiary of Diamond Bank. The three, according to Lanre Oloyi, spokesman of the commission, are among the 15 applications received from interested market operators willing to play the role at the end of a meeting of the board.
The approval of the trio, with the first two also prominent members of the Association of Issuing Houses of Nigeria, followed reports of a jostle by the nation's banks, with the huge capital base to also play the role. The report quoted one bank chief as saying: "The appointment as a market maker means a lot to us as a bank and any bank for that matter. This is so because of the perception of the public that such an appointment means endorsement by the regulatory authorities and by implication the general public.
"That was why when about two months ago some five banks were said to have been appointed as market makers, it caused a lot of sleepless nights for chief executives whose banks were not included and they swung into action immediately."
The decision to introduce market makers into the Nigerian capital market was reached last August as part of the recovery measures to check the persistent fall in the share prices at the stock market, which many argued, is despite the sound fundamentals of the economy, the market and most of the listed companies.
Guidelines For Market Makers
According to the guidelines for market makers released by the commission, simultaneously with those for share-buy back (a new Rule 31C), companies interested in playing the role are required to register with the SEC and with the Corporate Affairs Commission.
Such companies are also expected to have a minimum paid up capital of N2 billion and maintain sufficient liquid assets to cover its current indebtedness. Such role must also be stated in its Memorandum and Article of Association "that it can deal in securities in the capital market."
Such intending market maker is also required to register as a member of a self regulatory organisation (the Nigerian Stock Exchange in this case), as required by the enabling rules and regulations, aside from complying with the code of conduct of capital market operators and maintain a Fidelity Bond in with provisions of Rule 45, among others.
A market maker is required to "be a specialist in designated securities and hold itself out (by entering quotation in an inter-dealer communications system or otherwise) as being willing to buy and sell the designated securities for its own account on a regular or continuous basis."
Such a firm is also expected to ensure continued liquidity in the market at all times, while serving as a source of market information for the designated securities for which it stands ready at all times. It is also expected to facilitate a smooth trading atmosphere and engender market stability as well as promote price discovery.
The market maker, according to the rule, is under obligation to stabilise the market by ensuring continued liquidity, operate within the established bid and offer spread of a maximum limit of three per cent, subject to review. It is also expected to have the capacity for two-way quotes in relevant stock throughout the trading session on a minimum quote size of 100,000 units of shares.
It also under obligation to "have the capacity to deliver and settle transactions within the prescribed (T + 3) settlement cycle."
Market Experts Explain
Equities' analysts at UBA Global Markets Limited in a position paper on the workings of the market making policy in advanced economies and how its likely to operate in the country, explained some weeks ago that "market making involves a broker-dealer firm i.e. market maker, accepting the risk of holding a given number of shares of a specific stock or security in order to facilitate trading in that security. A market maker displays the bid and the offer quotes/prices for a guaranteed number of shares."
When a buy order is received, the explanation goes, the market maker sells from its inventory or seeks an offsetting order, all of which is aimed at keeping the financial markets running efficiently, because they are willing to quote both bid and offer prices for an asset. Such operators generate profits through their market-making activities from the spread, which are kept fairly tight as a result of the stiff competition between numerous market makers and are often fixed by each market maker. The spread between the bid price (which a buyer is willing to pay for a particular share) and ask/offer price (what a seller is willing to receive to part with the security essentially to sell the security) can actually affect the price at which a purchase or sale is made eventually.
"The bid-ask spread represents the profit that the market maker and specialist handling the transaction will make on each share or security (i.e. Ask - Bid = Profit to the market maker) where bid is usually lower than the ask, after any trading expenses, for example, custody fees.
"Market makers also participate in securities lending. Market makers borrow securities to fill buy orders and ensure tight, two-way prices. Security lending allows market makers to increase liquidity. The practice of security lending improves market makers' capabilities while it also allows market makers to significantly reduce the position that they need to hold to ensure delivery and mitigate risk of holding such positions," the report noted.
Inhibiting Factors
Despite the wonderful opportunities offered to the market by the market makers, the analysts have identified certain factors that may inhibit the implementation of market making, including the perceived market depth poor human capital, while the third factor- the circuit breaker put in the form of downward price movement was recently removed by the management of the NSE, resulting in significantly and even sharp decline in the market's indicators. Expectations are also high that a proper implementation of the strategy could reduce volatility, facilitate liquidity in the Nigerian financial market and increase market depth.
"We believe it is expedient to introduce the quote driven system into the operational structure of the Nigerian Stock Exchange.
"In our study of various markets, we observed that there is no strict quote driven market besides the NASDAQ (National Association of Securities Dealers Automated Quotations) and the London SEAQS. Most markets adopt a hybrid structure with the quote driven system adopted for less liquid, small capped equities and the order driven system used for mature, highly liquid stocks. For instance, the New York Stock Exchange, Russian market, Ukrainian market, London Stock Exchange and a host of others adopt a combination of the quote and order driven trading systems.
"Therefore, whilst we believe that market making can be applied to improve the workings of the equity market, we expect it to present a few challenges such as; the poor execution of clients' mandate, the undue use of privileged information, high cost of crossing stocks between accounts and other regulatory bottlenecks."
How It Works
Market makers put forward two-way quotes, while attempting to maintain a balance in the market, a reason why he/she would necessarily not reverse an unfavourable trade immediately but make a constant attempt to balance his book. He/She purchases in blocks and could benefit from existing intra-day bid-offer spread.
Assuming, for instance, continued, the report, the current price of PZ Cussons Nigeria is N25.00. "A market maker could simultaneously put a N24.75 buy order and a N25.25 sell order. If another trader sells to him at his proposed buying price of N24.75, he could do either of two things; hold his position for a while if he believes the price of PZ will rise further so he can sell it at a higher price intra-day, depending on the existing ask and bid sizes, or sell the stock immediately if he is indifferent. While being indifferent, supposing the stock started trading at N24.85 bid and N24.95 offer, he could either make the market again by putting a sell order at N24.95 and wait for someone to buy from him or take the market by selling at N24.85, making a N0.10 gain on each share.
"In developed markets, market makers have an edge over ordinary traders as they benefit from lower or zero commission and faster access to market information. In some equities trading systems like Archipelago (a technologically advanced equity trading system), market makers can even receive commissions for every act of market making as they are believed to serve as lubricants for the market, absorbing the extremely volatile price movements. However, market makers also have an obligation to give price quotes even when all the market participants want to trade in the same way."
A stockbroker remains an intermediary, licensed to buy and sell securities on behalf of clients, usually for a commission, while the "market maker, on the other hand, is an intermediary that is willing and ready to buy and sell securities for a profitable price. In other words, a stockbroker does not take principal risks while a market maker takes principal risks by holding or borrowing inventory.
A broker makes money by bringing buyers and sellers of securities together. Brokers have the authorisation and expertise to buy securities on an investor's behalf."
Conclusion
To ensure that appointed operators are able to effectively play their role as market makers at global standards, both the SEC and NSE have been challenged on the need for adequate market infrastructure; just as there is need for "an extension of trading hours to enhance the free-low of trades."
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