It is said that you don’t need to know everything to profit from it.
That is true with ETF’s (Exchange Traded Funds) but it doesn’t hurt to have some insight as to what makes them unique such as the creation and redemption process.
Increase Demand – Sharp Price Increase
A trading instrument such as an individual stock or bonds, have only so many units available. If a buyer wants to purchase a share of the stock for exam
ple, this trader contributes to the demand.
If the stock is hot or the trader wants a lot of shares, demand can easily outweigh supply at one price and the price of the stock will rise as buyers compete for every share available.
An ETF is much different in that unlike the stock example, a sudden rush of demand will not have an exaggerated effect on the price. How is this possible? Supply can be added to the market to attempt to meet the demand for the ETF.
The supply is added through a process called creation and redemption.
Creation Process For Supply and Demand Balance
In the creation process, think of stocks from different sectors all grouped together making up an index such as the S&P mid-cap 400. The price of the ETF is going to depend on the prices of all the stocks that are in the basket and when the prices rise, so does the value of the ETF.
What happens if there are not enough groups of a certain ETF to satisfy the demand?
They are created through the creation process with the help of an “authorized participant” which is usually a large institutional investor.
When the demand outweighs the supply, the authorized participant checks out what stocks that make up our example index: S&P mid-cap 400. The market maker gets the quantity of instruments needed, and the authorized participant sends them off to be bundled into the number of ETF’s needed.
The sale is completed between the market makers and purchaser with a small variance in price unlike when bidding for a limited amount of shares.
Selling the ETF
The second half of this process is called redemption and that is where someone wants to dump their ETF holdings but there already is enough supply currently in the market.
Before we get there though, the easiest way to unload the ETF is on the open market
The market maker offers up the ETFs on the open market and if they supply is not adequate, the sold off ETF’s are absorbed and that’s the end of the story.
Sometimes however, there is enough supply currently available and any sharp increase in supply can drive the price down and that is where the other option takes over.
Redemption Process Keeps Equilibrium
The market maker takes the ETF’s from the seller and once again, here comes the authorized participant.
The ETF is unbundled back into the individual securities and offered back up to each pool of like instruments.
Sound confusing?
The creation and redemption process is quite simple if you think of simply providing supply when needed to fulfill current demand. On the flip side, when an ETF is sold by an investor, if there is not enough supply, it is offered on the open market. If supply and demand is close to balance, the ETF is destroyed and each instrument is returned to which stock it came from.
The great thing is that this entire process happens behind the scene. As the investor, you place your order and your order is filled without you being directly involved in the creation or redemption process.