Stock market liquidity is the ability to execute large volumes of trades without disruption or price volatility. A liquid market allows for price discovery and fair valuations and lets investors enter and exit positions with minimal hassle and reduced risk.
Liquid markets have:
-Breadth: the bid/ask spreads that dictate the cost of reversing a position over a short period — the tighter the spread, the easier it is to enter and exit at the lowest cost.
-Depth: the availability of multiple bids and offers that mitigate wild swings resulting from large orders.
-Resilience: the ability to quickly recover from price swings due to shocks.
Exchanges, regulators, and capital market participants can enhance liquidity and improve efficiency of trading, which will in turn help attract more investments and stimulate economic growth.
To do this, GCC exchanges and regulators can focus on:
• Diversifying the investor base by attracting local and international institutional investors through liberalization, relaxing regulatory barriers, and promoting investor education and protection.
• Increasing the pool of securities and financial products by expanding local listings, launching derivative and ETF products, and creating market linkages.
Liquidity is a Win for All
-For investors: lower costs of trading and the ability to buy and sell an asset quickly.
-For issuers: attractive market entry as the cost of raising capital improves.
-For exchanges: greater market access, investor confidence, and ability to attract new stakeholders.
-For economies: companies’ ability to raise funds increases local and foreign investments, boosting productivity and increasing employment.
Market Making Importance
Much work needs to be done before market making can effectively enhance liquidity in GCC markets. Own-book market making’ has been in place in Bahrain – where SICO has operated in the field since 1996 – long before it was regulated. Market making has evolved in the absence of hedging tools as market operators like SICO have adopted a modified version in the form of liquidity provision schemes.
A market maker commits their own capital to provide liquidity for a stock. The operator profits from the bid/offer spreads from investor’s trading activities. There is also another P&L element due to inventory the market maker maintains which may rise or fall in value depending on stock prices.
GCC markets have introduced market making programmes as part of their revamp, which has coincided with the inclusion into major EM indices. Widespread adoption has yet to pick up, but we expect momentum to improve once market participants have had a chance to evaluate the positive outcomes.
This is an arrangement between an issuer and an operator acting as an agent to provide liquidity at an arm’s-length basis. This allows for the adoption of a quote-driven market, where multiple bids and offers are sent to the market while maintaining minimum market presence throughout the day.
Regulations exist to govern the relationship between the issuer and the liquidity provider to make sure the latter does not engage in price manipulation. Caps of 3-5% have been introduced on the holdings and shares held are considered part of the treasury shares in some GCC markets so don’t qualify for corporate actions such as dividends.
Why liquidity provision doesn’t lead to increased share prices?
The liquidity provision mandate and related regulations clearly define the liquidity provider’s role. Engaging in and providing bids and offers to increase the depth of the market while minimizing price spreads will encourage investors to trade. The provider has full discretion on the portfolio, thus working independently and free from issuer pressure from the issuer. The regulation is therefore clear the liquidity provider’s role: assist with price discovery without manipulating prices.
While deep liquidity provides room for price discovery and fair valuations, other factors such as investor appetite, financial position, and performance as well as the level of disclosures have significant impact, particularly for long term investors.
We believe strong investor relations (IR) programs also support price discovery and yield better results. IR in the region has become important to help investors understand companies beyond financial reports. Potential investors need to better understand company roadmaps and strategies, creating a link between investors and management. The Bahrain Bourse has recently introduced their Investor Relations Best Practice Guide to help companies adopt best practices and highlight the importance of IR. Research is also a great tool to help listed companies enhance their IR campaigns and attract sophisticated investors who look beyond the numbers.
What’s better for prices?
In the early cycle of the market developments, we believe liquidity provisions are more suited as a tool to create market depth and sustain it. With the development of these markets and introduction of hedging tools, the market making programs will become a viable option for participants.
(The author is chief capital markets officer at SICO)