Investment Banking - Underwriters and Market Makers

In the case of the underwriting function, the underwriters take the financial risk of their client in return for the financial fees. In the case of market makers' operations, financial institutions and large banks ensure enough liquidity by providing sufficient trading volume.

Underwriters and Market Makers – This is the 6th tutorial in 9 tutorials on investment banking.

• Part 1 - Investment Banking vs Commercial Banking
• Part 2 - Equity Research
• Part 3 - AMC
• Part 4 - Sales and Trading
• Part 5 - Private Placements
• Part 6 - Underwriters and Market Makers
• Part 7 - Mergers and Acquisitions
• Part 8 - Restructuring and Reorganization
• Part 9 - Investment Banking Responsibilities

In this tutorial, we discuss the following -

1. Underwriting
2. Market Making

• Underwriters in the underwriting role assume the client's financial risk in exchange for financial remuneration. As a result, financial institutions and big banks ensure enough trading volume to ensure ample liquidity in market makers' operations.
• An essential investment bank task in an IPO is underwriting.
• An individual who maintains market liquidity is referred to as a market maker. They assist in running the financial market efficiently. 
• The job of a market maker is to act as a middleman and present the buyer with a profitable price. If not, the seller keeps those shares and sells them at a profit in the future.

Underwriting

Let us now look at the overall framework. We have learned what the research looked at in sales and trading. We have also looked at raising capital. As we will move to underwriters and market makers, these are industry jargons that are very important for us to understand. What happens when discussing IPO if the company wants to raise $100 million? If they are unable to do so, then what happens? There is a risk associated with it. We assumed that the IPO might fail to mitigate the risk that investment banks underwrite an IPO. The investment bank will buy those shares if they are under subscription.

Now, let us discuss another important function of an investment bank in IPOs called underwriting. So, we hear a lot about investment banks’ underwriting for various IPOs. But what exactly does it mean? So let us take an example here to see what underwriting means. As discussed earlier, assume a small private company that wants to raise new securities, so we have discussed this earlier. So, they may inflate using Initial Public Offerings. But the problem is there may be risks associated with under-subscription.

What does this under-subscription mean? Suppose a company wanted to raise $100 million from the market. Under-subscription risk implies that they may not grow whatever they wish to raise. So not 100 million; maybe they can raise $50 million under subscription. So, there are investment bankers who underwrite the securities. It helps the firms grow the committed amount. Hence, this means that if an investment banker is underwriting the securities, he virtually guarantees that he will raise the amount committed to be raised. So how does the investment bank ensure this? So essentially, when an IPO comes, the stocks are given to the investor. Suppose there is under-subscription of any kind, e.g., to the extent of $10 million. So, the investment bank will absorb this $10 million worth of stocks, so we are essentially saying it will buy this share and sell it at that appropriate time to make a profit. So, underwriting means that virtually you guarantee that any amount of under-subscription will be absorbed by the investment bank. As you can see, the investment bank is assuming financial risk, the financial risk could be that, let us say, IPO was not successful, so the investment bank may have to buy the stock to an extent it was undersubscribed. Let us say the stocks stang after some time, which is a huge risk for the investment bank. That is why investment banks charge hefty fees during the underwriting scenarios when we talk about underwriting. In this process, they have to speak in detail with the risk department and compliance department about the risk or quantum of risk the investment banks can take concerning underwriting. So, we have understood that underwriting is one of the most important functions. Investment banks also enable market-making activities in the stock exchange. So, what is market-making? Why do investment banks play a very important role here? This underwriters’ and market makers’ video lets us look at that.

Market Makers

No. 2 is very interesting. It is related to the market maker. Now, what do you understand by being a market maker? So, there can be companies, investment banks, and market makers. A market maker is someone who ensures liquidity in the market. For example, there is a stock called ABC. This investment bank is a market maker for this stock ABC. When a market maker means that trades happen in the market, the role of a market maker is essentially to provide liquidity to the stocks. That could be done by either buying the shares or selling them shares. To explain this to you in a very basic way, let us take the example of ABC, for which investment banks are market makers. Suppose an investor wants to buy 1,000 shares of ABC, but his price is $50. If there is a seller in the market, he wants to sell this share of ABC at $100 for 1,000 shares. So now, if you look at the distance between $50 and $100 is too huge. So, you know the transaction may never get completed at all. What happens is that there may be few buyers and few sellers in this company altogether. A market maker’s role is to pitch in between and offer a lucrative price to the buyer, or the seller stores those shares and probably trades them later for a profit. Now, how will they do that? So let us assume that in one of the cases, this investment bank, a market maker, actually offers to buy this share at $75. So, there was a seller at $100 but a buyer at $50. An investment bank, a market maker, has a quota. So, there may be some sellers who may want to sell the stock. So, in that case, you know they may match, and this investment banking market maker will own this share. This market maker can secure the transaction by providing liquidity in the market. So, here comes in between, and they know how to create the market. On the other side, if he owns the stock, he can also look at selling the stock. If the investment bank owning 1,000 shares now wants to sell at $80. Instead of $100, you now try to sell at $80 so that you may find some buyers. You are doing it gradually because the bid and the ask spread were too high for the market maker. You had come between. Now, you have lowered the bid as a spread and ensured some liquidity in the market. This example was slightly exaggerated, but the bid-ask spread runs into only a few senses. In that way, these market makers have proved very efficient. They have been helping in the smooth running of the financial markets. Now that we have understood these two jargon underwriters and market makers.

• What is the Sellers Market?
• Dealer Markets Meaning
• Definition of Underemployment
• Market Makers