Bond Market-Making Needs Capital, Not Just Mandates

India’s renewed push to introduce a formal market-making framework for corporate bonds has been welcomed with predictable enthusiasm. After all, equity markets became liquid once continuous quoting and electronic trading arrived. Why shouldn’t bonds follow the same script? Because bond markets do not fail for lack of quotes. They fail for lack of risk-bearing capacity. And India’s own experience with government securities should have settled this long ago.

For decades, India has imposed so-called mandatory market-making obligations on Primary Dealers. These entities are required to provide two-way quotes, participate in auctions, and support secondary market liquidity. And yet, anyone who has traded government bonds knows the truth: outside the on-the-run benchmark maturities, liquidity is episodic, depth vanishes quickly, and spreads widen sharply once size enters the picture. Even in the sovereign bond market, the deepest, safest, and most standardised fixed income segment, mandated market making has never produced durable, balance-sheet-backed liquidity.

Not because PDs failed to comply, but because no rational intermediary will warehouse duration, funding, and mark-to-market risk unless the carry and capital economics compensate for it. Mandatory quoting did not alter that calculus. It created the appearance of liquidity, with screens flickering with prices that thinned out the moment real size sought execution.

Risk Capital
This history should temper expectations as India now seeks to replicate market making in the far more complex terrain of corporate credit.

India’s corporate bond market has expanded meaningfully in stock terms, but not in flow. Outstanding issuance has risen steadily, yet secondary turnover remains shallow, concentrated in AAA issuers, and sporadic beyond the highest-rated names. For most investors, “liquidity” still means holding to maturity or absorbing steep discounts under compulsion. The architecture of a market is visible; the continuous exchange of risk is not.

Enter market making, the policy world’s preferred cure-all. Appoint designated liquidity providers, mandate two-way quotes, layer in incentives, and liquidity, we are assured, will materialise. The difficulty is that this prescription draws on the stylised, textbook conception of market making rather than the capital-constrained, technology-driven version that governs modern fixed income markets.

In textbooks, market makers absorb order imbalances, warehouse inventory, smooth volatility, and earn the spread over time. Liquidity is structural and countercyclical. In real markets, modern market making is algorithmic, balance-sheet light, and ruthlessly conditional. Liquidity providers today thrive on speed, queue position, rebates, and order-flow prediction, not on holding bonds through adverse moves. They rent risk by the millisecond rather than warehouse it by the month.

Which means liquidity is abundant when markets are calm and evaporates precisely when markets become one-way.

This fragility is tolerable in equities because turnover is high, hedging is easy, and risk is quickly recycled. In corporate bonds - idiosyncratic, credit-sensitive, and illiquid by nature - it becomes fatal. Market making that works only in good weather is not market making. It is momentum following with a spread.

India’s credit market history confirms this. During IL&FS, DHFL, Yes Bank AT1 write-downs, and Franklin Templeton’s fund closures, liquidity disappeared not because platforms failed but because intermediation balance sheets retreated. Quotes may have survived; depth did not. Price discovery collapsed precisely when investors needed it most.

This is why India’s market-making push risks delivering quoted liquidity without tradable liquidity. Screens will tighten, dashboards will glow, and reform presentations will improve until volatility arrives, at which point market makers will widen spreads, shrink size, or simply step back. What remains will not be a market but a marcuum – a market with a vacuum.

Balance-Sheet Economics
The lesson from government securities is instructive. Mandatory market making cannot override balance-sheet economics. Even sovereign bonds could not be made liquid by obligation alone. Expecting corporate credit that is fragmented, risky, and funding-intensive to behave better is optimism masquerading as reform.

This does not mean market making is pointless. It means it must be built around how markets actually function.

First, inventory risk must be financeable. Without deep corporate bond repo markets, securities lending, and usable hedging tools such as credit indices and total return swaps, no one will warehouse credit risk at scale. Market making without financing infrastructure is not liquidity provision but an inventory suicide.

Second, incentives must reward executed liquidity, not displayed liquidity. Regulators must avoid mistaking quote counts for market depth. True liquidity is measured by size traded in stress, not spreads shown in calm. If incentives reward presence rather than performance, market makers will optimise for optics.

Third, investor participation must broaden beyond AAA. No intermediary can intermediate risk that investors structurally refuse to hold. India’s insurance, pension, and mutual fund regimes still penalise lower-rated credit. Unless those constraints evolve, alongside credible credit enhancement mechanisms, liquidity will remain trapped in the safest sliver of the market.

But even if all this is done, policymakers must accept a deeper truth:  modern market making is structurally procyclical. It compresses spreads in good times and disappears in bad ones. This is not failure but rational behaviour. Which means market making cannot be the sole pillar of liquidity policy. It must be complemented by credible backstops, including RBI repo facilities, collateral frameworks, and crisis liquidity tools, if India wants its bond markets to function across cycles rather than merely during rallies.

The uncomfortable conclusion is that the ultimate market maker is still the sovereign balance sheet. No algorithm can substitute for institutions that cannot withdraw when volatility rises. In stress, liquidity always migrates back to central banks and governments. Pretending otherwise is how systems end up surprised when screens go dark.

There is also a political economy dimension rarely acknowledged. Deep bond markets expose weak balance sheets, reduce regulatory discretion over credit allocation, and force risk to be priced rather than administered. That is precisely why corporate bond markets remain underdeveloped in bank-centric systems - not because of missing platforms, but because of missing appetite for market discipline.

Seen in that light, India’s market-making initiative is not merely a microstructure tweak. It is a stress test of institutional seriousness. Does India want a bond market that trades in both directions, or merely one that looks liquid in policy documents?

If market making becomes another regulatory slogan with quoting obligations, dashboards, and celebratory press releases, then India’s corporate bond market will remain what it largely is today: a market that exists on paper, appears on screens, but disappears when anyone actually tries to use it.

Liquidity is not a UI feature. It is a balance-sheet commitment.

Until India’s framework is built around that reality — not around mandatory quotes — market making will improve appearances without fixing the plumbing.