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The Inner Workings of ETF Creations and Redemptions

This article was originally published on ETFTrends.com.

By VanEck via Iris.xyz

Although the creation and redemption of ETF shares takes place largely behind the scenes for most investors, the process is a defining feature of the ETF structure.

Setting the Stage

As a starting point, let’s discuss the differences between the secondary and primary markets for ETF shares.

The secondary market, which includes the widely recognized securities exchanges, is where investors buy and sell existing shares of ETFs. For example, if you wish to buy 2,000 shares of an ETF, you typically place an order with a financial advisor and purchase those shares at market price from other sellers in the secondary market.

The primary market refers to where ETF share creations and redemptions take place in large specified units of 50,000 shares or multiples thereof. It provides an additional “layer”, or source, of liquidity that can be accessed for large orders or when demand exceeds supply, or vice versa, on the secondary market. Typically, large financial institutions, authorized participants, and market makers 1  transact in the primary market. Market makers buy and sell ETF shares in the secondary market to provide liquidity and may also serve as authorized participants.

Authorized Participants

Authorized participants (APs) are an important part of the creation and redemption process. Usually large broker-dealers or custodial institutions that have executed an agreement with the issuer, APs are the only entities that may transact directly with the ETF issuer, and as such, play a critical role in helping ensure fair pricing and ETF liquidity. When the secondary market price of an ETF falls out of line with its net asset value (NAV) 2 , an AP may create or redeem shares of the ETF, bringing prices back in line with the NAV.

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