Market Making
Market making is the practice of continuously quoting both a bid price (to buy) and an ask price (to sell) for a financial instrument, providing liquidity to other market participants and earning the bid-ask spread as compensation for taking on inventory risk.
Market makers were the lifeblood of liquid markets, playing a structural role that ensured participants who wanted to trade could do so promptly without requiring an exactly matching counterparty at that instant. By simultaneously maintaining both a willingness to buy at the bid and sell at the ask, market makers absorbed imbalances in supply and demand, managing their resulting inventory positions through hedging and intermarket arbitrage. Their profit was the bid-ask spread — the difference between what they paid to buy and what they received on sale — but this spread had to compensate for inventory risk, adverse selection risk (the risk that the counterparty knew more about the instrument's value), and operational costs.
In Indian equity markets, designated market makers (DMMs) operated under formal frameworks established by exchanges. BSE's market maker scheme for SME IPO listings required appointed market makers to provide continuous two-sided quotes in newly listed SME stocks for a minimum period post-listing, addressing the liquidity gap that small-cap stocks experienced when institutional coverage was absent. Without such market making obligations, many SME stocks on BSE would have faced extended periods of thin order books and wide spreads that deterred participation.
For options market making on NSE's equity derivatives segment, a cohort of registered trading members and proprietary desks provided continuous quotes across strike prices and expiries for index options (Nifty and Bank Nifty weekly and monthly contracts) and select stock options. These participants typically managed their options inventory using delta hedging — continuously adjusting the underlying futures position to remain approximately delta-neutral — while making money from the volatility risk premium and from the bid-ask spread. This activity concentrated significantly in weekly expiry options, which by 2023 accounted for the vast majority of NSE's options premium turnover.
The profitability of market making was highly sensitive to the spread environment. Competitive electronic markets with many market makers compressed spreads to near-zero on the most liquid instruments — Nifty 50 index futures typically traded at a one-rupee spread throughout the trading day — meaning that scale and low operational latency were essential for viability. Less liquid instruments offered wider spreads but carried commensurately higher inventory and adverse selection risks, requiring more sophisticated hedging infrastructure.
Regulatory scrutiny of market making activity in India addressed concerns about manipulative practices that superficially resembled legitimate market making. SEBI's surveillance infrastructure distinguished between genuine two-sided liquidity provision and strategies that used quote activity to create artificial impressions of liquidity or to manipulate prices — an important distinction that shaped compliance requirements for firms engaged in high-volume quoting activity on Indian exchanges.