Simply Put: Market Making in ETFs

Two friends met for lunch and were discussing about new rules regarding Market Making in ETFs.

Ravindra: Hey! What are you doing on your phone constantly?

Ayush: Recently, I have started investing in ETFs as I wanted to invest in a product to replicate Nifty 50. But it is not tracking the index closely. Do you know why?

Ravindra: Oh, SEBI is trying to address that issue with new rules proposed in a circular through market making in ETFs.

Ayush: Wait a minute! Who is market maker?

Ravindra: I remember you recently went on a trip to Singapore, and you exchanged rupees for Singapore dollars at SBI.

Ayush: Yeah, he was quoting two different rates for buying and selling Singapore dollars.

Ravindra: Exactly, SBI was acting as a market maker of currencies who creates liquidity for a financial product.

Ayush: Ok. So, how does one create liquidity in ETFs?

Ravindra: See, ETF units trade like stocks on the exchange and its price would be determined by demand and supply of its units, distinct from the demand and supply of its underlying shares. If, for some reason, the ETF is in high demand and there aren’t enough units traded in the market to cater to that demand, the price of an ETF might deviate from its underlying value which is the NAV.

Ayush: So how does SEBI plan to address this issue?

Ravindra: ETF units will continue to be traded in the exchange among buyers and sellers. But institutional investors who redeemed/purchased ETF units directly from the fund house will now also go to the exchange and provide the much-needed liquidity.  Also, fund houses need not be regularly engaged in buying/selling activities. SEBI now mandates that one can route his ETF units’ trade through fund house only when the transaction value is more than ₹25 crore beyond which fund houses can create more ETF units. Consequently, for below-₹25-crore trade, one would be compelled to go to the exchange and that’s how liquidity can be created.

At the same time, SEBI has asked all the fund houses to appoint at least two market makers for each ETF who will come into the picture when there is no seller when one wants to buy or when there is no buyer when one wants to sell. In such cases, market maker assumes the counter position in a way that ETF units’ price remain in line with the actual asset value (NAV).

Ayush: Oh, now I am slowly getting it. But what if, by any chance, market makers themselves don’t have enough units to create liquidity? Can market makers go to the fund house then?

New mandate

SEBI has asked fund houses to appoint at least two market makers for each ETF to create liquidity

Ravindra: Yes, then, market makers can directly go to the fund house for creation of units to be given to the buyers or vice-versa in case of redemption, irrespective of the ₹25 crore rule.

Ayush: That seems a good move to create liquidity. But despite all these rules, can the price of an ETF unit still be different from its actual value?

Ravindra: Yes, despite all efforts, there may be times when ETF units’ price may not be equal to its actual value, due to changes in demand and supply at a single point in time. SEBI has tried to take care of this too. During such scenarios, trades of less than ₹25 crore can also be made through fund houses directly.

Ayush: Okay, I got that. But ultimately, how can I know if ETF units are trading at its actual value?

Ravindra: Yes, for this we need to look at iNAV (Indicative NAV). iNav is the true value of ETF which should be disclosed by the fund houses on a real-time basis with the maximum lag of 15 seconds, as per the SEBI mandate. As a result, investors can check if there is any difference between price and NAV continuously.

Ayush: These are really good efforts made by SEBI for bringing in liquidity for the ETFs.

Ravindra: Yes, let’s just hope these moves resolve the liquidity issues and ultimately fulfil goals of ETF investors.

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