How Do ETFs Trade?
An exchange traded fund (ETF) is an investment vehicle whose shares trade intraday on stock exchanges at market-determined prices.
ETFs are unique because they offer two markets for trading:
1. The secondary market, where most investors trade
2. A primary market that supports the ETF’s liquidityand allows them to trade close to Net Asset Value (NAV) throughout the day.
As you can see, the ETF liquidity ecosystem has many participants. Does the ETF trading ecosystem seem a little too complex? Let's break Figure 1 down to understand the key ETF trading activities point by point.
Who Are the Major Liquidity Players in the ETF Market?
ETFs’ unique creation and redemption process and secondary market trading involve a number of capital markets players who contribute to the ETF liquidity ecosystem, including:
Exchange
While ETFs are generally listed on one exchange, trading of ETF shares occurs across many trading venues. These include national securities exchanges (e.g., NYSE, Nasdaq and CBOE), alternative trading systems (ATSs or “dark pools”), and over the counter.
Broker/Dealer
Brokers and dealers execute trades on behalf of clients by routing orders to trading venues or by matching buyers and sellers directly. Dealers buy and sell securities for their own account. They charge commissions for their services to execute and settle trades.
- Institutional Sales and Trading Desk: Some brokers have a dedicated institutional trading desk that specializes in facilitating large trade executions at defined prices. They may quote a market for a given ETF at a given size (risk trade) or act as an AP to place a creation or redemption order on the client’s behalf with the ETF issuer (end-of-day NAV trade).
Authorized Participants (AP)
APs are the only counterparties allowed to enter creation and redemption orders with the fund. They are typically self-clearing broker-dealers that serve many functions, including acting as dealers in ETF shares in the secondary market and as agents for market makers and other liquidity providers to create/redeem ETF shares.
Market Makers
Simultaneously making offers to buy (bid) and sell (ask) securities at specified prices, market makers provide two-sided liquidity to other market participants. They facilitate the exchange of securities between end investors by bridging the gap between the time when natural buyers and sellers enter the market. Market makers profit from the spreads of their bid/ask quotes, as well as arbitrage opportunities between an ETF’s NAV and its market price. This also helps with price discovery and keeps the ETF prices in line with its NAV.
- Lead Market Maker (LMM):Selected by the Primary Listing Exchange, LMMs are required by the exchange to meet minimum performance standards, such as best bid and offer, minimum displayed time and minimum quoted spread. In exchange, LMMs receive economic benefits, such as lower transaction fees and higher rebates from the exchange.
- Electronic Market Makers (EMM): EMMs employ algorithmic and high-frequency trading technology to harvest bid/ask spreads with relatively high trading volume in a short period of time without human interaction. They usually minimize using their balance sheet by making their positions market neutral by the end of the day.
Derivative Trading Desk
These desks actively transact in the underlying ETF to dynamically hedge their position(s), as they facilitate transactions on a variety of financial instruments for institutional clients. Additionally, ETFs seeking to track indices linked to other structures, such as swaps and futures, are often used in relative value arbitrage between vehicles.
Short Sellers
Short sellers provide liquidity, as they tend to be selling into demand when share prices appreciate, and conversely looking to buy back shares when prices decline. For example, if most investors are optimistic about the asset’s future performance, ETF share prices increase, leading to more demand of ETF shares. Short sellers who hold a contrarian view will borrow shares from brokers and sell them when there is more demand for purchases and then buy them back later, when most investors are selling.
Create-to-Lend Desk
Create-to-lend desks create ETF shares (through an AP) for the purpose of lending them to clients seeking to borrow the shares. They usually hedge their positions to minimize price risks.
Each of these capital markets players contributes to ETFs trading more efficiently throughout the day, which benefits both buyers and sellers. There are also economic benefits for the capital markets participants.
Who Are the ETF Issuer’s Liquidity Players?
The ETF issuer develops ETF products, determines fund investment objectives, manages the ETF portfolio according to the fund’s objectives and oversees day-to-day operations. Within the organization, these four functions deal with market liquidity:
Portfolio Manager and Trading Desk
Portfolio managers manage the ETF portfolio, seeking to achieve the investment objective. They determine the composition of ETF baskets. Portfolio managers’ trading desks execute trades as directed by portfolio managers. They work with liquidity providers of underlying securities to source liquidity, minimize trading costs, and seek best execution.
Capital Markets Team
Building relationships with APs, exchanges, market makers, trading desks/platforms, and other liquidity providers, the capital markets team plays an active role in promoting competitive markets to improve the ETF liquidity ecosystem. Given their relationship with market participants and insight into primary and secondary market activity, they are a critical resource for investors looking to execute large ETF trades efficiently.
Product Development
ETFs rely on arbitrage activities to keep the fund’s market price in line with its NAV. And so, when designing an index for an ETF to track, the product development team ensures the ETF basket is liquid enough to efficiently manage the fund from a liquidity perspective. This, in turn, allows market participants to effectively create/redeem ETF shares and keep prices in line with NAV.
Liquidity Risk Management
The liquidity risk management team monitors fund underlying asset liquidity and funding liquidity using a variety of risk metrics and quantitative models in normal and stress scenarios to ensure the ETF’s ability to meet client redemption in a fair and orderly manner. They engage with portfolio managers, traders, product managers, and other stakeholders to address any liquidity issues identified.
There's Plenty More to Learn About ETFs
Visit our ETF Education Hub to explore other ETF topics.
