A Look Behind the Curtain – ETF Primary Markets

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Exchange-traded funds (ETFs) can provide investors with superior liquidity, lower costs, and greater tax efficiency relative to other investment vehicles. A look “behind the curtain” at the workings of the primary markets helps to explain what enables ETFs to offer such distinctive characteristics for investors. Our primer below breaks it down.

The workings of the ETF primary market
ETF shares are created and redeemed in the primary market between the ETF and an Authorized Participant (AP). APs, large financial institutions with contractual ability to transact directly with an ETF, provide considerable underlying liquidity in the ETF market and increase market transparency by keeping ETF prices close to their net asset values.

Share creation transactions are conducted in-kind¹ by exchanging ETF portfolio securities for ETF shares. As such, the AP bears trading costs for purchasing portfolio securities (in a share creation transaction) or selling securities received (in a share redemption transaction) in the open market. Since redemption trades are executed in-kind, and the Internal Revenue Code enables the ETF to forgo realization of a related taxable gain/loss, by extension ETFs can operate with lower costs and greater tax efficiency.

As illustrated below, trading in the primary market exists on an over-the-counter basis between the AP and ETF issuer and is facilitated through the ETF’s distributor, custodian, and transfer agent. Our primary market creation graphic (Figure 1) shows how the AP works with an ETF issuer, with the underlying securities delivered from the AP to the ETF, and the AP receiving newly created ETF shares in exchange. Conversely, for a primary market redemption order, the AP delivers existing ETF shares in exchange for the underlying ETF portfolio securities.

Figure 1: A Primary Market Creation Order

How is ETF liquidity determined by the primary market?
Appreciating the true liquidity for an ETF depends upon the liquidity of the underlying portfolio securities that an ETF holds. If that basket of securities is liquid, this makes the ETF itself liquid. Ultimately, an ETF is as solvent as its least liquid underlying holding. Since ETF shares can be continually created to meet demand, the ETF’s average trading volume and total assets do not fully determine liquidity.

The hierarchy of ETF liquidity illustration (Figure 2) shows the greatest liquidity levels are at the bottom of the pyramid, with secondary market orders on top, and primary market orders on the bottom.

The Hierarchy of ETF Liquidity

ETF shares that are traded throughout the day in relatively small order lots occur on the secondary market; these are broker-facilitated transactions between ETF investors and market makers. Any ETF share trading on the secondary market has been previously created in the primary market and will change hands from investor to investor based on demand.

However, if a very large lot order were to be executed, it would likely trigger a transaction in the primary market and the available liquidity would be the result of the underlying portfolio securities that make up the creation basket.

How are ETF shares priced in the primary and secondary market?
An AP transacting in the primary market benefits from the arbitrage opportunity that may arise when the ETF share price differs from the underlying security basket value. This arbitrage opportunity presents a risk-free way for the AP to realize a profit. An AP’s primary market participation may also enhance working relationships with market makers and ETF issuers.

With the ETF share price scenarios below, Figure A depicts ETF shares priced at a premium. The ETF is trading in the market at $25 and the value of the underlying security basket is $20. The AP steps in to buy the basket of securities at $20 in exchange for ETF shares in the primary market. The AP immediately sells the ETF shares in the secondary market to realize a profit of $5, which in turn puts downward price pressure on the ETF in the secondary market.

Figure B presents ETF shares priced at a discount. The ETF is trading in the market at $15 and the value of the underlying security basket is $20. Here, the AP purchases ETF shares in the secondary market, creating upward price pressure on the ETF shares in the secondary market. The AP immediately redeems these ETF shares on the primary market, receiving the underlying basket of securities worth $20. The AP can now sell these underlying securities on the open market, realizing a profit of $5.

Premium and discount pricing activity can be repeated until there is no arbitrage opportunity available. As illustrated in Figure C, the ETF is priced equivalent to its underlying security basket value, which is considered a price equilibrium where the ETF shares are fairly valued in the market.

ETF Share Price Scenarios

Understanding ETFs’ potential efficiency to provide liquidity and pricing in line with intrinsic value, even in volatile market environments, discloses the importance of the primary market mechanism. Simply put, the primary market’s behind-the-scenes workings enhances ETFs’ added value to today’s portfolios.