Missing liquidity provider

India’s capital markets are facing a new test of regulatory design. At first glance, the issue appears technical: how banks collateralise guarantees and intraday funding extended to brokers for proprietary trading. But for market intermediaries, the debate is much larger. They believe the RBI’s latest directive could reshape the economics of liquidity provision in one of the world’s most active equity derivatives markets.

The central question is this: should a broker taking a speculative proprietary position be treated the same way as a broker or trading firm providing liquidity through largely hedged market-making and arbitrage strategies?

Broker associations argue that the answer should be no. Their concern is that the RBI’s revised framework, while aimed at strengthening banking safeguards and reducing speculative trading using bank financing, does not clearly distinguish between directional proprietary trading and hedged liquidity-providing activity. As a result, participants who help maintain market depth, narrow bid-ask spreads and support price discovery may face reduced capacity to provide liquidity due to lower availability of bank financing, potentially affecting overall market efficiency.

Industry participants estimate that collateral attributable to proprietary trading represents approximately 2.5 per cent of the total collateral available with Clearing Corporations. At the same time, proprietary participation at the National Stock Exchange (NSE) accounts for approximately 30 per cent of cash-segment volumes, 32 per cent of futures volumes and around 50 per cent of options premium turnover, reflecting a meaningful role in overall market activity. Despite proprietary trading’s relatively small share of the overall collateral pool, it plays a critical role in supporting market liquidity and facilitating efficient market functioning.

The RBI’s objective is understandable. The central bank wants banks to be adequately protected when they extend guarantees or funding lines for proprietary trading activity. Under the revised framework, such exposures will need to be backed by 100 per cent cash or cash-equivalent collateral. At least half of this collateral will have to be in cash, while the balance can consist of permitted instruments such as government securities or cash equivalents.

From a banking-risk perspective, the logic is straightforward. Proprietary trading can carry market risk. If banks provide guarantees or credit facilities for such activity, regulators want the exposure to be fully secured. But brokers argue that the framework treats all proprietary trading activity as a single category. Some traders take directional bets. Others run arbitrage strategies with hedged positions and continuously provide buy and sell quotes. It is this second category that the industry wants regulators to recognise separately.

Ketan Marwadi, a senior broker and member of the Commodity Participants Association of India (CPAI), says: “The industry is not contesting RBI’s concern around bank-funded speculation.” The point, he argues, is that proprietary trading is also used for liquidity provision, arbitrage and hedged market-making strategies. “Nobody is asking for speculative activity to be funded by banks. The only thing we have been asking is: please allow bank facilities with 50 per cent collateral to continue for liquidity-providing or hedged positions,” says Marwadi. According to Marwadi around Rs50,000 crore of liquidity could be affected once the new norms are implemented. He said clearing corporations have around Rs11 lakh crore in collateral, including nearly Rs1.2 lakh crore through bank guarantees and around Rs1 lakh crore through intra-day facilities.

Liquidity’s invisible role

Liquidity is often noticed only when it disappears. In normal market conditions, investors assume they can buy or sell securities quickly, at narrow spreads and without significantly moving prices. Behind that smoothness lies the work of brokers, proprietary desks, arbitrageurs, high-frequency traders and market makers who continuously absorb order flow.

Liquidity providers stand ready to buy when others want to sell and sell when others want to buy. They earn small spreads across large volumes while managing risk through hedged positions. In derivatives markets, they also help connect prices across the cash, futures and options segments, improving price discovery and reducing distortions.

“Liquidity providers form an integral part of the capital market ecosystem. However, there is often a tendency to mix liquidity providers with directional traders or speculators, despite the two serving fundamentally different functions. Liquidity providers play a critical role in ensuring fair and efficient price discovery across various contracts and instruments traded in the capital markets. By continuously trading across contracts, they enhance market depth, improve liquidity, reduce impact costs and enable efficient participation by a broad range of market participants,” says Anup Gupta, Chairman, Bombay Stock Exchange Brokers’ Forum (BBF).

If liquidity weakens, the impact may not immediately show up in headline volumes. It can appear in wider bid-ask spreads, thinner order books, higher impact costs and more volatile price movements during large trades. For retail investors, this may mean poorer execution. For institutions, mutual funds and insurers, it can increase the cost of entering and exiting positions.

Marwadi gives a simple example. When the market opens, there are already hundreds of thousands of quotes across different contracts. These are not necessarily placed by long-term investors buying for delivery or selling holdings. Many of these quotes, he says, come from liquidity providers running multiple hedged strategies.

For foreign portfolio investors and mutual funds, the issue is especially important. Their concern is often not just return, but the ability to enter and exit positions without high impact costs. If a mutual fund faces large redemptions and needs to sell, there must be enough liquidity on the other side. If an FPI is entering India, it evaluates whether the market can absorb large orders efficiently.

If proprietary trading-participant capacity reduces, participants may reduce quoting or scale back positions. Further, liquidity could weaken if order books become thinner or large trades become more expensive to execute.

Marwadi compares liquidity providers to the axle of a car. “However powerful or attractive the vehicle may be, without the axle connecting its wheels, it cannot function properly,” he says, arguing that liquidity providers may appear small in the overall market structure but play a crucial role in keeping the system efficient.

The regulatory gap

The industry’s main concern is not tighter risk management. It is the absence of a formal liquidity-provider category. The RBI framework does allow banking facilities with 50 per cent collateral for recognised market makers. But brokers say this has limited practical relevance because formal market-maker recognition in India exists mainly in SME segments and newly launched contracts on a case-by-case basis. In the highly active equity and derivatives markets, there is no broad regulatory framework that recognises entities performing market-making-like functions.

“Market maker, as per SEBI’s definition, is a very narrow definition. Today, market makers are only in illiquid contracts, like SMEs or new exchanges, not in liquid contracts or derivatives contracts,” says Marwadi.

This creates a gap between market reality and regulatory classification. Several firms may be providing liquidity every day (akin to activity performed by market makers), but because they are not officially recognised as liquidity providers or market makers, their activity is clubbed with general proprietary trading, and the 100 per cent collateral requirement would apply to them.

“In contrast, directional traders or speculators take positions based on their view of future market movements. While speculation itself serves a legitimate market function, it is distinct from liquidity provision. We agree with the RBI’s contention that speculative activity should be undertaken using the participant’s own capital rather than through borrowed bank funds,” says Gupta.

The concern is that banks cannot make a distinction unless the securities market regulator first creates one. If SEBI formally recognises substantially hedged liquidity providers as market makers, banks could potentially treat such activity under the RBI’s carve-out for market makers. Without that recognition, all proprietary trading would be viewed through the same lens.

To address this, broker bodies have sought a formal liquidity-provider framework.

“ANMI fully supports the RBI’s objective of strengthening risk management and ensuring prudent banking safeguards. However, it is important to distinguish between speculative proprietary trading and genuine liquidity-providing activities that are largely hedged and play a vital role in market efficiency. Liquidity providers contribute significantly to market depth, tighter bid-ask spreads, efficient price discovery and lower execution costs for investors.

A regulatory framework that formally recognises and monitors such participants through objective risk-based parameters can help strike the right balance between financial stability and market liquidity. As India’s capital markets continue to deepen and attract global investors, preserving efficient liquidity mechanisms will be critical to maintaining competitiveness, reducing impact costs and supporting overall investor confidence,” says Kamlesh Shroff, President, Association of NSE Members of India (ANMI).

According to Marwadi, the proposal has been sent to the Industry Standards Forum and will now need regulatory consideration. If SEBI finds it appropriate, it may be taken to the Secondary Market Advisory Committee and then shaped into a formal regulatory framework. Only after such recognition can the RBI decide whether bank funding to registered liquidity providers should be treated under the market-maker carve-out.

The proposed solution

The industry proposal has three broad elements. First, liquidity providers should be formally recognised by SEBI. This would give regulatory identity to entities that provide two-way market depth and operate with defined obligations and substantially hedged positions.

Second, liquidity-providing activity should be conducted through separate trading codes. One code would cover own-account trading, including directional or speculative positions, where bank funding would require 100 per cent collateral. The second would be a liquidity-provider code, where activity could be eligible for bank support with 50 per cent collateral only if it meets strict risk and hedging conditions.

Third, eligibility should be based on objective risk parameters. The industry is proposing the use of SPAN margin as a measurable test of whether a portfolio is substantially hedged.

SPAN, or Standard Portfolio Analysis of Risk, is already used by clearing corporations to assess portfolio risk. It recognises offsets between positions and captures whether a portfolio is directional or hedged. A high SPAN component usually indicates greater market risk. A lower SPAN component suggests that the portfolio is substantially hedged.

The industry has suggested that a proprietary trader should qualify as a liquidity provider only if its SPAN margin is less than 50 per cent of the total margin requirement. Marwadi explains the logic through the current derivatives-margin structure. For example, for a long position on NIFTY at 25,000, SPAN margin is around 9.2 per cent and Extreme Loss Margin (ELM) is around 2 per cent, taking total margin to about 11.2 per cent. If the SPAN component is to fall below 50 per cent of the total margin, the SPAN must reduce materially: from around 9.2 per cent to below 2 per cent. According to him, this is possible only if the book is substantially hedged with offsetting positions.

“If a trading firm maintains SPAN at 50 per cent of the total margin, it means it has to bring SPAN down from 9.2 to 2. Now, that is only possible if the firm is 80 to 90 per cent hedged,” says Marwadi.

Monitoring is the next question. If liquidity providers receive differentiated treatment, how will banks know that the activity remains hedged and does not become speculative? The industry’s answer is to use existing clearing-corporation infrastructure. Clearing corporations already take multiple margin snapshots at random times during the day. Marwadi says five random intraday snapshots and one end-of-day snapshot can be shared by clearing corporations directly with banks for each broker or client code. If the SPAN component exceeds the prescribed threshold, banks can demand additional collateral or shift the account to the 100 per cent collateral requirement.

This matters because the proposed framework does not rely merely on self-certification. It uses clearing-corporation data, separate trading codes and risk-based thresholds. The industry also argues that the historical track record of banking facilities has been strong. Marwadi says there have been negligible cases of bank-guarantee invocations involving capital-market intermediaries over the last 10 years.

Cost of capital

At the heart of the issue is capital efficiency. Liquidity providers typically work on thin margins. Their business depends on deploying capital efficiently across large volumes. If more capital is locked up as cash collateral, the economics of liquidity provision changes. Bank guarantees have traditionally allowed brokers to meet margin requirements at the exchanges without tying up the entire amount in cash. Under the revised framework, if guarantees need to be fully backed by cash or cash-equivalent collateral, firms’ ability to provide margin would reduce significantly.

The first impact may be on brokers’ cost structures. But the eventual burden could be borne by investors through poorer execution, wider spreads and higher transaction costs.

Regulators now face a delicate balance. The RBI’s concern about bank-funded speculative risk is valid. Banks should not be exposed to under-collateralised proprietary trading. At the same time, deep and liquid capital markets are also a public good. They reduce transaction costs, improve price discovery and support confidence among investors.

The solution may lie in a framework that protects both objectives. A formal liquidity-provider regime could allow regulators to ring-fence genuine market-making activity while denying benefits to directional traders. But such a system would need safeguards. Liquidity providers would have to be registered, their activity segregated through dedicated trading codes, and their risk profile monitored using objective metrics such as SPAN. If they breach the criteria or shift into directional trading, the benefit should be withdrawn.

For ordinary investors, the debate may appear distant. Terms such as bank guarantees, SPAN margin and proprietary trading codes are not part of everyday investing vocabulary. But liquidity affects every investor. It determines whether a trade is executed smoothly, how wide the spread is and how much the market moves when a large order is placed. If liquidity providers reduce activity because funding availability becomes more constrained, investors may not see a new explicit charge. Instead, the cost may be embedded in execution – wider spreads, poorer fills and higher impact costs.

The RBI directive was designed as a banking safeguard. But it has opened a larger discussion on market design. Should all proprietary trading be treated alike?

“Given their unique role and contribution to market efficiency, liquidity providers should be recognised as a separate category of market participants and treated distinctly from speculative traders. Such recognition would be in the long-term interest of the Indian capital markets. We note that broker associations have already proposed a framework to identify and regulate liquidity providers as a distinct class, and we believe these proposals merit serious consideration,” says Gupta.