ETF Create-Redeem: A $17 Trillion Market with 90% Off-Exchange

Introduction

Exchange-traded funds (ETFs) have become a popular investment vehicle, with over $17 trillion in assets under management globally. ETFs offer investors diversification, transparency, and liquidity.

One of the key features of ETFs is their create-redeem mechanism. This mechanism allows authorized participants to create and redeem ETF shares in exchange for baskets of underlying securities. This process helps to ensure that the ETF's market price tracks the value of its underlying assets.

The create-redeem mechanism is also used to manage the supply and demand for ETF shares. When there is high demand for an ETF, authorized participants can create new shares to meet that demand. Conversely, when there is low demand for an ETF, authorized participants can redeem shares to reduce the supply.

Pain Points

Despite the many benefits of ETFs, the create-redeem mechanism can also create some challenges.

Off-Exchange Trading

One of the biggest challenges is that the create-redeem mechanism can lead to off-exchange trading. This occurs when authorized participants create or redeem ETF shares directly with the ETF issuer, rather than through an exchange. Off-exchange trading can lead to price distortions and reduced liquidity for ETF investors.

:Settlement Delays

Another challenge is that the create-redeem mechanism can lead to settlement delays. This occurs when authorized participants are unable to deliver the underlying securities to the ETF issuer on time. Settlement delays can cause problems for investors who are trying to sell their ETF shares.

Motivations

Authorized participants are motivated to engage in the create-redeem process for several reasons.

• Arbitrage: Authorized participants can profit by buying ETF shares on the exchange and redeeming them with the ETF issuer for a basket of underlying securities. If the value of the underlying securities is greater than the market price of the ETF shares, the authorized participant can make a profit.

• Inventory Management: Authorized participants can use the create-redeem mechanism to manage their inventory of underlying securities. For example, an authorized participant may need to create ETF shares to meet demand, or redeem ETF shares to reduce their inventory of a particular security.

• Market Making: Authorized participants can use the create-redeem mechanism to make markets in ETFs. This involves buying and selling ETF shares on the exchange in order to maintain a fair and orderly market.

Effective Strategies

There are several strategies that can be used to reduce the risks and challenges associated with the create-redeem mechanism.

• Use of On-Exchange Trading: Investors should encourage authorized participants to create and redeem ETF shares through an exchange. This helps to improve liquidity and reduce price distortions.

• Settlement Improvements: ETF issuers and authorized participants should work together to improve settlement efficiency. This can help to reduce settlement delays and improve liquidity for ETF investors.

• Regulatory Oversight: Regulators can play a role in reducing the risks associated with the create-redeem mechanism. For example, regulators could require authorized participants to disclose their create-redeem activity and could impose penalties for late settlement.

Step-by-Step Approach

Authorized participants coordinate trading and settlement

The process of creating and redeeming ETFs involves coordination between authorized participants (APs), broker-dealers, and the ETF issuer. Here is a step-by-step breakdown of the process:

1. Creation and redemption orders are placed

When an investor wants to buy or sell an ETF, they place an order through their broker-dealer. Creation orders are for buying new shares, redemption orders are for selling existing shares. Broker-dealers bundle these orders and send them to an AP.

2. APs determine if they can create or redeem in-kind

APs assess whether they can create or redeem shares in-kind, meaning they can deliver the underlying securities directly to the ETF issuer instead of cash. In-kind creations and redemptions are more efficient and less costly.

3. APs create or redeem ETF shares

If an AP can create or redeem in-kind, it will do so directly with the ETF issuer. If it cannot create or redeem in-kind, it will instead buy or sell the underlying securities on the open market.

4. ETF issuer issues or redeems shares

The ETF issuer issues new shares to the AP in exchange for the underlying securities in a creation. In a redemption, the AP delivers ETF shares to the issuer in exchange for the underlying securities it holds.

5. Settlement

The final step is settlement, where the AP delivers the underlying securities to the ETF issuer in creation or receives the underlying securities from the ETF issuer in a redemption.

Conclusion

The create-redeem mechanism is a key feature of ETFs that helps to ensure that they track the value of their underlying assets. However, this mechanism can also create some challenges, such as off-exchange trading and settlement delays. By understanding the challenges and using effective strategies, investors can reduce the risks associated with the create-redeem mechanism and benefit from the many advantages of ETFs.

Key Stats

• ETFs have grown rapidly in recent years, with assets under management increasing from $1.3 trillion in 2010 to $17 trillion in 2022.

• The create-redeem mechanism plays a key role in ensuring that ETFs track the value of their underlying assets.

• Off-exchange trading and settlement delays are two of the challenges associated with the create-redeem mechanism.

• Investors can reduce the risks associated with the create-redeem mechanism by using effective strategies, such as encouraging on-exchange trading and supporting regulatory oversight.

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