Market Making in SME IPOs, Explained

Most promoters I sit with in the months before an SME listing know the words “market maker” and very little else. It shows up as one line in the merchant banker’s fee proposal, one agreement in the stack of issue documents, and a small reservation in the offer structure. Then the stock lists, the listing-day excitement fades, and the market maker becomes the single most important participant in the counter. This note explains what the market maker actually does, why the law insists on one, who pays for it, and what you should put in writing before you sign.

If you are earlier in the process, start with my complete founder’s guide to the SME IPO. This piece assumes you already know the broad route and want to understand one moving part properly.

Why market making is compulsory on the SME platform

A mainboard stock has thousands of buyers and sellers on any given day. An SME stock often does not. The investor base is narrow, the free float is small, and trading happens in fixed lots rather than single shares, so the ticket size per trade is high. Left alone, many SME counters would go days without a single trade, and an investor who wanted to exit would simply have no one on the other side.

SEBI’s answer is written into Chapter IX of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018. Regulation 261 requires the lead manager to ensure compulsory market making through stock brokers of the SME exchange for a minimum period of three years from the date of listing. In plain words: for three years, someone registered with the exchange is obliged to stand in the market, ready to buy and ready to sell your shares, so that liquidity does not depend purely on whether other investors happen to show up that day.

Note where the obligation sits. The regulation puts it on the lead manager, not on you. The lead manager discharges it by appointing one or more market makers, who are stock brokers empanelled for this role with BSE SME or NSE Emerge. In practice the market maker is often a group entity or long-time partner of the merchant banker. That is permitted, but it is something you should know and see disclosed.

What the market maker is actually obliged to do

The obligations come from two layers: the ICDR Regulations set the principle, and the exchange circulars set the operating detail. The operating detail has been revised more than once over the years, so treat what follows as the mechanism and check the latest BSE SME or NSE Emerge circular for the current numbers before you rely on any of them.

Two-way quotes. The core duty is to post a buy price and a sell price at the same time, continuously, for a prescribed share of the trading day. At the time of writing, the exchange frameworks require two-way quotes for at least 75% of the time in a trading day. A quote that appears for ten minutes at the open and then vanishes does not meet the obligation, and the exchanges monitor compliance.

A maximum spread. The gap between the buy quote and the sell quote cannot be anything the market maker likes. The exchange prescribes a ceiling on the spread, and the framework has allowed that ceiling to vary with factors such as the market maker’s inventory and the liquidity of the counter. Ask your banker to show you the current table rather than quoting a figure from memory.

Minimum quote size. Each quote must be for at least the prescribed minimum quantity, expressed with reference to the market lot of your scrip. A quote for one lot on a counter where investors need to move ten lots is technically a quote and practically useless, which is why this matters.

Buying out odd holdings. Regulation 261 also requires the market maker to buy the entire shareholding of a shareholder in one lot where the value of that holding is less than the minimum contract size allowed for trading on the SME exchange. This protects the small holder who ends up with less than one tradeable lot and would otherwise be stuck.

The three-year minimum. The obligation runs for at least three years from listing. The market maker agreement will say how a market maker can be replaced during that period and what notice is required. The exchange must be kept informed, and a replacement has to be in place so that the counter is never without one.

Inventory: where the market maker’s shares come from

A market maker cannot quote a sell price without shares to sell. So the issue structure reserves a slice of the offer for the market maker, usually labelled the Market Maker Reservation Portion in the offer document. The market maker subscribes to this portion at the issue price with its own money, like any other allottee. That allotment becomes its opening inventory.

The ICDR Regulations set a floor on this: the market maker’s inventory on the date of allotment must be at least 5% of the specified securities proposed to be listed on the SME exchange. The reservation portion in the offer document is sized with that requirement in mind, so 5% is the starting point for the structure.

Inventory also works in the other direction. When investors sell and the market maker keeps buying, its inventory grows. The exchange framework recognises that no market maker can absorb unlimited selling, so it sets threshold levels of inventory. Once holdings cross the prescribed upper threshold, the market maker can be relieved of the obligation to keep posting buy quotes until inventory comes back down, while it still has to provide sell quotes. This is the single most important thing for a promoter to understand: market making supports liquidity; it does not guarantee a price floor. In a sustained sell-off, the market maker’s buy side has a limit, and when that limit is reached, the price finds its own level.

One more rule that surprises promoters. The promoters’ holding is not eligible to be offered to the market maker. You cannot hand over part of your locked-in or unlocked stake to seed the market maker’s inventory, and you should not try to build any side arrangement that achieves the same thing informally.

Who pays, and how the arrangement is structured

There are two separate money flows, and promoters sometimes blur them.

The inventory is the market maker’s capital. The market maker pays for its reservation portion at the issue price and carries the price risk on those shares. If the stock falls, the loss on inventory is the market maker’s loss. The company does not fund it, and the promoter must not fund or guarantee it.

The service fee is an issue expense. For providing the service over the three-year period, the market maker is paid a fee under a market making agreement, typically a tripartite agreement between the issuer, the lead manager and the market maker. The fee is borne by the company as part of the issue expenses and has to be disclosed in the offer document, alongside the lead manager’s fee, underwriting commission and the other costs. The structure varies from mandate to mandate: some agreements fix an annual or monthly fee, some bundle it into the lead manager’s overall package. I break down how this sits in the full cost stack in my piece on SME IPO cost and timeline.

Because the fee is paid over years while most of the lead manager’s fee is earned around listing, the market making agreement is one of the few documents in an SME IPO that keeps working long after the issue closes. Read it as carefully as you read the engagement letter.

How market making affects post-listing liquidity and price

A good market maker changes the experience of holding your stock. An investor can see a live buy price and a live sell price for most of the day, can exit a position without waiting for a stranger to appear, and can form a view on value from a price that is actually tradeable. That matters for your shareholders, and it matters for you: a counter that trades in a tight, honest range is far easier to raise further capital on, or to migrate to the main board from, than one that prints a trade every other week.

A weak market maker does the opposite while technically complying. Quotes sit at the edge of the permitted spread, sizes stay at the minimum, and the quote disappears whenever the counter gets busy. The stock then trades in bursts and gaps, and a single large seller can move the price sharply because the other side of the book is thin.

Two things market making does not do. It does not set the price; supply and demand from real investors set the price, and the market maker quotes around it. And it does not protect you from an issue that was priced too high. If the IPO was priced on an aggressive multiple, the market maker’s inventory will fill up as early allottees exit, the buy side will hit its threshold, and the stock will drift toward a level the market accepts. Responsible pricing at the IPO stage does more for post-listing stability than any market making agreement. The same logic applies to listing-day noise, which I discuss in my explainer on grey market premium.

What a promoter should negotiate before signing

You do not appoint the market maker directly, but you are a party to the agreement and you pay the fee. That gives you the right to ask questions. These are the points I raise with the lead manager on every SME mandate.

1. Identity and track record. Which broker will act as market maker, is it a group entity of the lead manager, and on which other SME counters has it made markets? Ask for the name so you can look at how those counters have actually traded over the last year or two.

2. Quote quality in writing. The exchange prescribes minimums. Ask whether the market maker will commit to anything better than the minimum on spread and quote size, and what reporting you will receive on quote uptime and trades.

3. Inventory sizing. The 5% floor is a floor. On a counter where you expect a large number of retail allottees, a slightly larger reservation gives the market maker more room on the sell side in the early weeks. Discuss this with the banker when the issue structure is being set, not after the offer document is filed.

4. Fee and payment schedule. Is the fee fixed for three years or escalating? Is it paid upfront or over the period? A fee paid entirely upfront leaves you with no leverage if quote quality drops in year two.

5. Replacement and exit. What happens if the market maker resigns, is suspended, or simply performs badly? The agreement should set out the notice period, the lead manager’s obligation to find a replacement, and how the fee is adjusted.

6. Conduct clauses. The agreement should state plainly that the market maker acts independently, that the company and promoters will not give it trading instructions, and that each party will comply with the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003. This protects you as much as anyone.

These points belong in the same conversation as the rest of the banker’s proposal, which is why they appear in my checklist for choosing an SME IPO merchant banker. Market making norms and costs also differ in detail between the two platforms, so read my comparison of BSE SME and NSE Emerge before you settle on an exchange.

Common pitfalls

Treating the market maker as a price support desk. The most dangerous misunderstanding. Any arrangement where the promoter, the company or a connected person funds the market maker, guarantees its losses, or asks it to hold the price at a level is outside what the framework allows and can attract action for price manipulation. The market maker provides liquidity; it is not there to defend your valuation.

Reading the fee line and nothing else. Promoters negotiate the market making fee down and never read the obligations, reporting or replacement clauses. A cheaper market maker that quotes at the edge of the spread is expensive in every way that matters.

Promoter group trading in the counter. Once listed, any purchase or sale by promoters and their relatives is subject to lock-in, insider trading rules and disclosure requirements. Promoter family members trading around the market maker’s quotes is the kind of pattern that surveillance picks up. Speak to your compliance officer before anyone in the promoter group places an order.

Forgetting the three-year clock. Market making is a minimum of three years, and companies that plan to migrate to the main board need to understand how the obligation interacts with migration. Check the current exchange position when you plan that step rather than assuming.

Ignoring the disclosure. Everything about the market maker, including its name, the reservation portion and the fee, goes into the offer document. If the arrangement you have agreed cannot be disclosed plainly, it should not be agreed. The same test applies across the document, as I explain in my section-by-section guide to drafting the DRHP.

Questions promoters ask me

Can the company choose its own market maker? The obligation sits with the lead manager, who appoints the market maker from brokers empanelled with the exchange. You can and should ask for a say, and a reasonable lead manager will discuss the choice with you, but the appointment runs through the banker.

Does the market maker guarantee that the share will not fall below the issue price? No. It provides two-way quotes and holds inventory within limits. Once its inventory crosses the exchange’s upper threshold, it can be relieved from the buy side until inventory reduces. There is no price guarantee, and you should be wary of anyone who implies one.

Can there be more than one market maker? The regulations contemplate market makers competing with each other for better quotes, and some issues do appoint more than one. Whether that is worth the extra cost depends on the size of the issue and the expected investor base.

What happens after three years? The compulsory period ends, and the counter trades on its own liquidity unless the company and a broker agree to continue on commercial terms. The companies that handle this well are the ones that used the three years to build a genuine investor base through regular disclosure and results communication.

Bottom line

Market making is the part of an SME IPO that starts working the day the listing ceremony ends. The law makes it compulsory for three years because SME counters would otherwise freeze. The market maker brings its own capital for inventory, charges a disclosed fee that the company pays, posts two-way quotes within exchange limits, and steps back from buying when its inventory hits the threshold. It improves liquidity; it does not hold up a price. Know who your market maker is, get quote quality and reporting into the agreement, pay the fee over time rather than upfront, and keep the promoter group well away from the counter’s order book. Because the exchange circulars on spreads, quote size and inventory thresholds change from time to time, check the current BSE SME or NSE Emerge circular with your lead manager before you sign. If you are working through this for your own listing, the first call is usually 45 minutes.