Market regulator Securities and Exchange Board of India (SEBI) recently took an important step to boost liquidity in exchange traded funds. The SEBI had directed AMCs to appoint at least two market makers (MMs), who are members of the stock exchanges, to provide continuous liquidity for ETFs.

The role of market makers is crucial in illiquid counters/products, as they ensure trading is get completed. They offer on both (buy and sell) the sides, the best possible price for traders to make trading complete and thus liquidity.

Expense ratio 

The new norms allow AMCs to charge expenses by providing incentives to market makers on ETF expense ratio. To make the market making process less capital-intensive, the regulator allowed net settlement between the cash leg of the transaction in units of the ETF by the market maker and the consequent transaction in the underlying basket by the ETF.

MMs should be permitted to transact in the basket of securities underlying the ETF against equivalent transactions in units of ETFs and transfer the net obligation of such transactions to the ETF for unit creation or redemption. The AMCs should be allowed to create or redeem units of ETFs without upfront payment of 100 per cent value of such units or in advance delivery of such units by the MMs, respectively, SEBI said.

At a time when retail investors are rising exponentially, the intent of SEBI is clear. It wants retail investors to concentrate on relatively less risky passive funds in secondary markets rather than dabbling directly in individual stocks.

And, market making is necessary as retail investors (due to cost) cannot create units, which market makers can do and make easier to buy and sell ETFs, at a price that is close to its actual net asset value.

Largely it’s EPFO show

SEBI move will be a game-changer if ETFs take off strongly at the exchanges. According to industry sources, pension fund EPFO is the largest owner of ETFs, while just 5-10 per cent is being held by the retail investors. The assets under management of equity ETFs is also small even after the Employees’ Provident Fund Organisation invests 15 per cent of its incremental inflows.

However, market making exercise alone is not sufficient to boost the acceptance of ETFs. While SEBI has done its part, the onus is now on exchanges, mutual funds and brokerages to create awareness of the products and mechanism to retail investors.

Besides, exchanges should also ensure quotes provided by the market makers are in sync with the actual net asset value for investors who wish to buy or sell ETFs through exchanges platform.

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