Primary market: creations and redemptions
Primary market activity—the process by which ETF units are created and redeemed—plays a crucial part in determining an ETF’s true level of liquidity.
Creation is the process by which approved Authorised Participants and stockbrokers apply for units in an ETF and introduce additional shares 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. 500,000 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 can also redeem units through the same process in reverse. The AP 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.
From the ETF and its investors, this process serves to keep the market price of the units and the net asset value (NAV) in line. The Authorised Participant can profit from creating or redeeming units in a number of ways, including arbitrage, inventory management, customer facilitation and equity finance/stock loan.