An attractive feature of ETFs is their ability to be traded throughout the day. The key to a smooth, profitable trading experience is liquidity. The true liquidity of an ETF is represented by the liquidity of the underlying securities and is a function of the creation and redemption process.
In general, creation and redemption of units are facilitated by “authorized participants” (APs), such as a designated broker or market maker who interacts with the fund in large blocks of units, typically 50,000 or 100,000 units. When the ETF wants to create new shares, it turns to the AP to help provide liquidity in the form of more shares to offer in the market. The ETF provider interacts directly with the AP in what is called the primary market.
APs can also remove ETF shares from the market. An AP can buy a block of ETF shares on the open market and transfer them to the ETF provider for the value of their underlying securities (in cash and/or securities).
This mechanism facilitates the primary market in ETFs and works through the in-kind transfer of a basket of securities, or the transfer of cash, to (or from) the fund.
The Creation Redemption Process
This creation redemption process performs important functions:
- It creates liquidity for the ETF shares by meeting the supply and demand needs of investors who trade on an exchange (also known as the secondary market).
- It helps keep an ETF’s market share price consistent with the fund’s NAV.
Analysis of trading activity in an ETF needs to be viewed in the context of the liquidity of the underlying securities it holds. This creation and redemption process is the unique conductor of liquidity between the ETF and its underlying assets.