[Viewpoint] Market Making Function and Liquidity

Like all assets, stocks require both buyers and sellers for a transaction to occur. If there are no buy or sell orders, or if the trading conditions differ significantly, transactions are difficult to execute. For example, even if there are buy and sell orders, if the bid and ask prices differ markedly, trades cannot take place. If this situation persists for a long time, the lack of trading disrupts price continuity, increases stock price volatility, and halts the market’s most important function: price discovery. In other words, the market fails to perform its proper role. This problem is especially likely to occur in small-cap stocks with low liquidity, which are often perceived as risky in the market, leading to lower stock prices.

If appropriate bid and ask prices and order volumes are consistently provided on both the buy and sell sides, the continuity of trading and the price discovery function will operate, allowing the market to recover its proper function. This activity is called ‘market making,’ and the entities that provide it are called ‘market makers.’ Market makers play a crucial role as liquidity providers in stock exchanges worldwide. For example, the New York Stock Exchange (NYSE) in the United States has traditionally developed around market makers known as specialists. Although their functions and numbers have been reduced, Designated Market Makers (DMMs) now perform the same role. The Korea Exchange also operates a market maker system. The less frequently traded a stock is, the more market makers can promote trading, improve liquidity, and enhance price continuity. From an investor’s perspective, the assurance of continuous trading makes transactions easier and reduces trading costs.

Market making services are not free. The difference between buy and sell prices through trading represents the potential profit for market makers, but they are constantly exposed to the risk of losses due to unfavorable changes in stock prices and inventory conditions. Therefore, exchanges in various countries encourage active participation by offering benefits such as exemptions from securities transaction taxes.

Recently, the market maker system has become an issue in Korea. It has been reported that authorities are considering excluding large-cap or highly liquid stocks from the securities transaction tax exemption related to market making. In other words, this tax exemption benefit would apply only to low-liquidity stocks.

Of course, market making activities are more necessary for stocks with relatively fewer orders, i.e., low-liquidity stocks. However, the lower the liquidity, the greater the volatility, exposing market makers to higher risks of price fluctuations and inventory imbalances, increasing the likelihood of losses. If losses continue in low-liquidity stocks, market makers may lose the incentive to engage in market making for those stocks. According to research by Professor Cao and others, NYSE specialists offset losses incurred in low-liquidity stocks with profits earned from high-liquidity stocks during market making activities. This provides important implications for the authorities’ policy to reduce the scope of tax exemptions.

If the list of securities transaction tax-exempt stocks is drastically reduced, and market makers’ profits from high-liquidity stocks significantly decrease, it may become difficult to sustain market making activities for low-liquidity stocks that have been incurring losses. These stocks could experience reduced liquidity, which may ultimately lead to decreased price efficiency. Investors could be exposed to greater volatility and bear higher trading costs. While authorities may anticipate increased tax revenues, if overall market making activities decline and market-wide liquidity decreases, it is questionable whether the expected increase in tax revenue will materialize. This issue requires considerable deliberation.

Hee-Jun Ahn, Professor, School of Business, Sungkyunkwan University

This content was produced with the assistance of AI translation services.