What is the creation/redemption mechanism and the role of the authorized participant?
When an investor buys or sells ETF shares on an exchange, it is trading on the secondary market. Here, the investor trades with other investors and/or market makers, in the same way stocks are being traded. However, unlike stock trading, the supply of ETF shares is not fixed, as ETF shares can be created or redeemed on the primary market. On the primary market, the ETF sponsor – the ETF fund manager – interacts with authorized participants (APs) to facilitate the creation and redemption of ETF shares. Through this mechanism, more ETF shares can be created when there is excess demand and vice versa, i.e. ETF shares can be redeemed when there is excess supply. This process that ensures that most of the time an ETF trades close to its fair value (or NAV) in the secondary market.
The ETF sponsor may appoint one or multiple parties to act as APs for a given ETF fund. These are usually large banks or market makers. When the AP creates ETF shares, they deliver the underlying basket of financial instruments to the ETF issuer in exchange for ETF shares. This happens in a pre-determined block of shares called a creation unit (typically between 10,000 and 100,000 ETF shares). When the AP wants to redeem ETF shares, the process works in reverse and the AP delivers ETF shares to the issuer who will return the underlying basket of instruments. The process of exchanging the basket of instruments for ETF shares is called ‘in-kind creation’. Alternatively, APs may also purchase creation units with cash. The ETF issuer then uses the cash to buy the financial instruments that are held by ETF fund itself.
Note that the role of the AP is different from the market maker. Sometimes, the same party assumes both roles, but this is not necessarily the case. The role of the market maker is to provide liquidity on the secondary market by showing bid and offer prices, whereas the AP is responsible for the creation and redemption of ETF shares on the primary market.
What does this mean for the markets?
The AP’s ability to create and redeem shares is important to keep ETF prices in line with the net asset value (NAV) – the combined value of the ETF’s underlying basket. Because ETFs trade like stocks on the secondary market, the price fluctuates during the trading day. If there is a large imbalance between supply and demand, the ETF price may start to deviate a lot from the NAV. The APs have an economic incentive to create or redeem ETF shares, as they can make a profit from buying the instrument with the lower price and selling the one with the higher price.
The creation/redemption mechanism and the presence of APs in the primary market gives ETFs an edge over closed-end funds, for which there is no such process in place. As there is no balancing mechanism, these funds may trade large premiums of discounts compared to their NAVs.
A second advantage of this mechanism is that the trading costs associated with the creation/redemption activity are borne by the AP. As such, it is a more efficient way for the ETF issuer to acquire or divest the fund. This differs to that of a mutual fund, where the fund incurs trading fees when there are inflows as the fund needs to buys the underlying instruments.
The price of an ETF and the fair value of the underlying basket (NAV) are both $100 when the market opens. Imagine that during the trading day:
The NAV falls to $95 while the price of the ETF remains at $100 due to high demand. In this case, the ETF fund is trading at a premium. In response, the AP could create ETF shares through buying the underlying basket at $95, delivering it to the ETF issuer in return for newly created ETF shares and sell them for the market price of $100 for a profit of $5 (minus transaction costs and fees). By selling newly created ETF shares, the price of the ETF will be driven back in line with its fair value.
- The NAV increases to $105 while the price of the ETF remains at $100. The ETF fund is undervalued and trading at discount. The AP could now buy ETF shares in the market at $100 and redeem them with the issuer in return for the underlying basket. The AP can sell the underlying securities in the market for $105 for a profit of $5 (minus transaction costs and fees). By taking the undervalued ETF shares out of the market and redeeming them, the gap between the ETF price and its fair value will narrow until they are back in line.