Liquidity is a key feature of exchange traded funds (ETFs) versus some alternative methods of gaining investment exposure. But investors who are not fully familiar with how ETFs are structured and traded may use too narrow a definition of liquidity. Due to their open-ended structure, ETFs offer liquidity through both a primary and a secondary market, which are defined as follows:
Assessing the overall liquidity of an ETF requires us to consider the liquidity in both the primary and secondary together.
The Role of Authorised Participants and Market Makers
Some of the main participants in the ETF ecosystem - Authorised Participants and Market Makers – are described below. We look at their roles in providing liquidity.
Authorised Participant (AP): AP’s have fully executed legal documentation which gives them the ability to create new ETF units or redeem existing ETF units directly with the fund manager. These transactions regulate supply of ETF units in the secondary market, which serve to keep the market price of the units and the net asset value (NAV) in line. The AP participates because it can profit from creating or redeeming units in a number of ways, including arbitrage, inventory management, customer facilitation and equity finance/stock loan.
Market Maker: This is an all-encompassing term referring to a firm that is willing to provide a price to a buyer or a seller of an ETF and therefore makes markets on ETF units. Market makers provide prices either on an exchange or over-the-counter (OTC):
What is the Difference Between an Authorised Participant and a Market Maker?
Authorised Participants have the ability to create or redeem ETF units for funds with which they have properly executed legal documentation. If a professional client was to contact an Authorised Participant and inquire about trading an ETF, the Authorised Participant might be able to make a market in that specific ETF for this client.
There is a distinct and important difference between making a market when asked (as in the above example) and being an Exchange Market Maker with publicly available prices posted. Usually, although not always, Market Makers are also Authorised Participants.
Creation and redemption of ETF units
Creation and redemption of ETF units takesplace in the primary market and are direct transactions between the ETF managers and Authorised Participants.
Creation is the process by which additional units are introduced to the secondary market. Authorised Participants create fund units in large increments —known as creation units —by assembling the underlying securities of the fund in their appropriate weights to reach creation unit size (e.g. 50,000 units) and then delivering those securities and/or cash to the fund. In return, the Authorised Participant receives units, which they can then sell in the secondary market, increasing the supply of units that can be traded by other investors.
Authorised Participants also have the ability to redeem units through the same process in reverse. The Authorised Participant collects large increments of units —known as redemption units —in the secondary market and then delivers them to the fund in exchange for cash and/or the underlying securities in their appropriate weighting equalling the redemption unit (e.g. 50,000 units). This reduces the supply of units available in the secondary market.