SPDR ETF Capital Markets Group & SPDR ETF Strategy and Research Team
Understanding ETFs’ creation/redemption process gives investors insight into additional liquidity they can access.
Bid-ask spreads are determined by the bid-ask spread of the underlying securities, the liquidity of those securities, execution costs and market risk.
When trading in the secondary market, investors should consider market and limit orders; for large notional orders or block orders, engaging with institutional trading desks can provide additional liquidity support.
Creation/Redemption Process — The Primary Market
Becoming familiar with the ETF creation/redemption process is key to understanding the true extent of an ETF’s overall liquidity and achieving more efficient execution from a wider selections of funds. The creation and redemption process for ETFs takes place in the primary market and is facilitated by authorized participants (APs). APs are US-registered, self-clearing broker dealers who regulate the supply of ETF shares in the secondary market.
Creation is the process by which APs introduce additional shares to the secondary market. During this process, APs deliver the underlying securities to the fund sponsor in return for ETF shares. For redemptions, APs deliver ETF shares to the fund sponsor in return for the underlying securities. These transactions are executed in large increments known as unit sizes, which vary from 10,000 to 600,000 shares.
The ability to introduce additional shares into the marketplace on a daily basis demonstrates precisely why ETF trading volume is not an all-encompassing measure of the fund’s overall liquidity. In order to understand the full liquidity of an ETF, investors must also consider the liquidity of its underlying securities.
Why Does an AP Create or Redeem ETF Shares?
There are a number of reasons why an AP creates or redeems ETF shares, including: arbitrage, inventory management, customer facilitation, and create to lend. The two reasons that are the most applicable to investors are customer facilitation and arbitrage.
Customer Facilitation APs have the ability to create or redeem ETF shares for clients in order to access additional liquidity beyond the secondary market. For example, if a pension fund is interested in acquiring $50 million of ETF XYZ, they may consider working with an AP to facilitate a creation. Additional details can be found in Section 3: Buying and Selling an ETF.
Arbitrage APs can create or redeem ETF shares in order to take advantage of potential arbitrage opportunities in the market. For example, if shares of ETF XYZ are trading at $55.00 in the secondary market and the value of the underlying securities is $54.95 per share, there is an inherent arbitrage opportunity. In order to realize this opportunity, the AP would sell ETF shares at $55 and hedge their position by buying the corresponding underlying basket of securities for $54.95, thus locking in the $0.05 profit. The AP can deliver the underlying securities to the fund sponsor in return for ETF shares in order to flatten out their short position in the ETF. This hypothetical example results in a $0.05 profit for the AP. The key takeaway for investors is that this process keeps the ETF market price in line with the value of its underlying securities due to the consistent arbitrage opportunity for APs and institutional trading desks.