Liquidity Enhancement Scheme

A brand-new contract has a circular problem. Nobody trades it because nobody trades it.

A buyer will not come if he cannot sell later. A seller will not come if there is no buyer. The order book stays empty, and the exchange cannot argue anybody out of it.

The usual answer is to pay somebody to quote. A market maker is a class of member obliged to provide liquidity by giving two-way quotes at all times, on terms the exchange prescribes.

A Liquidity Enhancement Scheme is the framework SEBI provides for exactly that. It exists to make newly available commodity derivative contracts on the exchange platform more liquid, and to bring better participation into the market.

So it is not a rule about how to trade. It is a support structure, aimed at the one problem a new contract cannot solve by itself.

Watch the date. The workbook gives two, in two different chapters, and they do not agree.

What the scheme is. SEBI has provided for the Liquidity Enhancement Scheme — that is, for market making — to make the newly available commodity derivative contracts on the exchange platform more liquid. The workbook says LES has been introduced to increase liquidity in the markets and to bring better participation.

What a market maker owes. Chapter 1 defines it: a class of members who are obligated to provide liquidity in the exchange in the relevant commodity by giving two-way quotes at all times, on such terms and conditions as the exchange may prescribe from time to time. In the workbook's taxonomy, market makers are a subset of speculators, alongside day traders and position traders.

The two dates, stated both ways. Chapter 6, section 6.8, says SEBI provided for the Liquidity Enhancement Scheme by a circular in July 2019. Chapter 10, section 10.2.2, says SEBI had already come up with guidelines under the Liquidity Enhancement Scheme on 9 October 2018. The workbook does not reconcile the two. Carry both. If a question offers only one of them, take the one it offers; if it offers both, know that both are printed in your paper.

Why Chapter 10 raises it at all. The context there is investor protection. The market for some individual commodities is not very liquid, and it is very difficult to unwind an existing position in times of need; separately, investing in individual commodities through sophisticated instruments like derivatives requires specific knowledge and expertise that a lay investor may not possess. LES is offered as part of the answer to the first of those two risks, not the second.

No figure attaches to the scheme. The workbook gives no incentive amount, no cap, no tenure and no eligibility threshold for LES. The Rs 75 crore and Rs 500 crore Average Daily Trading Volume floors that sit nearby in Chapter 2 are index construction tests for composite indices, not LES tests, and should not be carried across.

Put a rupee figure on the problem LES exists to fix, using the workbook's own illiquidity illustration. A gold call option for a two-month expiry at a given strike is quoting Rs 2,014 bid and Rs 2,187 asked, so a participant who buys at market pays Rs 2,187.

The spread is Rs 173 on a premium of roughly Rs 2,100 — more than 8% of the premium itself. The workbook classes this as an indirect cost of participation: bid-ask spread and impact cost, which participants do not explicitly pay but which arise from market imperfections or a lack of liquidity in certain contracts.

Gold options carry the underlying futures' lot of 1 kilogram, quoted per 10 grams, which is 100 quotation units. So for a hedger who has to get in and straight back out:

Round trip cost of the spread = 173 x 100 = Rs 17,300 per lot

before a rupee of brokerage, CTT, stamp duty, SEBI turnover fees or GST.

Now suppose a market maker under a Liquidity Enhancement Scheme is committed to two-way quotes in that contract, and the spread tightens to Rs 2,095 bid / Rs 2,115 asked, a spread of Rs 20:

Round trip cost = 20 x 100 = Rs 2,000 per lot

The hedger keeps Rs 15,300 per lot that he would otherwise have surrendered to the spread — and he never sees a bill for either amount, because impact cost is invisible by construction.

The workbook does not join these two passages itself; the arithmetic is the inference. But it is the entire commercial case for paying a member to stand in a contract that nobody else wants to quote.

Chapter 6 (Trading Mechanism), section 6.8, which opens the participants discussion with LES, and Chapter 10 (Codes of Conduct and Investor Protection Measures), section 10.2.2, which raises it again as a partial answer to illiquidity risk. Chapter 1's participant list supplies the market maker definition that LES depends on.

Expect a definition question — LES is market making, meant to make newly available commodity derivative contracts more liquid and bring better participation — and possibly a date question, where the honest answer is that the workbook prints July 2019 in Chapter 6 and 9 October 2018 in Chapter 10.

• Two dates in the workbook, and they disagree. July 2019 in Chapter 6, 9 October 2018 in Chapter 10. Neither is presented as a correction of the other.
• LES is market making, not a margin concession. It supports members who quote; it does not reduce anybody's initial margin.
• It targets newly available contracts. It is not a general liquidity subsidy applying to every contract on the exchange.
• A market maker gives two-way quotes at all times. Quoting only one side is not market making, and the obligation is continuous.
• Market makers are a subset of speculators in this workbook, grouped with day traders and position traders. They are not a separate class of participant alongside hedgers and arbitrageurs.
• No figure attaches to the scheme. There is no incentive amount, cap, tenure or eligibility threshold in this paper. The Rs 75 crore and Rs 500 crore ADTV floors belong to composite index construction.
• A paid quote cannot create volatility or understanding. Chapter 2 blames thin index liquidity on the law of averages and on limited awareness too, and LES addresses neither.