The following opinion feature was first published in the Business Daily.
The Nairobi Securities Exchange (NSE) is working with various stakeholders to develop a comprehensive framework and requisite regulations to enable market makers, short sellers and stock lenders to operate in the domestic capital market.
To some Kenyans ‘market making’ and ‘short selling’ may sound slightly ominous and manipulative terms. But these are common in many global exchanges and are an important tool for building liquidity – the numbers of shares being traded – in a market.
Liquidity is the lifeblood of any exchange; it is the ease with which shares can be bought and sold and is critical for buoyant secondary trading.
Some smaller exchanges can suffer from a lack of liquidity – as NSE has on some occasions. Investors want to be able to trade when they choose. Listed companies, on their part, are always looking for liquidity in their own stock, as it tends to lead to a fair market-driven valuation.
An investor on the biggest exchanges – London, New York or Hong Kong – would take for granted that they could trade in a stock at a moment’s notice. For this to occur as it does in these jurisdictions there must be someone buying or selling at the other end of that transaction.
In those bourses, market makers and stock lenders play an absolutely vital role in ensuring that tradable stock is available at any time of the trading day.
In smaller markets, like NSE, if you want to buy equities or bonds, your broker needs to find a willing seller and vice versa.
And from my broking experience, I know it is very difficult to find a buyer or seller for exactly the same value, in the same company, at exactly the same time as you are.
This is where a market maker comes in. These are firms, who meet stringent capital and operational requirements, which are obligated to provide a two-way price in certain securities in order to ensure that there is always a certain amount of liquidity in these stocks.
This means that investors on NSE always have the opportunity to buy or sell.
And it also means that the market can be more sensitive to the performance of, and announcements by, companies listed on the exchange. For a market maker to operate effectively, it must have the ability to engage in short selling.
The firm will need the ability to sell short in order to meet its obligations (i.e. to sell stock which they do not currently have to buyers). This shortfall is covered before settlement from later purchases or from stock borrowing.
In order for the market makers to be able to borrow stock, so as to do their crucial job, a stock lending and borrowing framework needs to be put in place.
Other traders who need to meet unexpected delivery shortfalls or run a short selling operation can also use this service.