Market makers are a little-seen segment of the market, but they’re there, working hard to keep the markets and exchange traded funds (ETFs) running efficiently.

A market maker, according to an Investopedia definition, is a broker-dealer firm that assumes the risk of holding a certain number of shares of a security in order to ease the process of trading the security.

Don Dion for The Street explains that both true market makers and proprietary traders are looking for the fastest way to hedge trades, create units and maximize ETF trading capabilities. Some other facts about market makers:

• When an ETF launches, the lead market maker will create the first units, delivering the contents of a product’s basket in exchange for shares of the ETF
• Next, the lead market maker will generally sell shares of the ETF to buyers and hedge the sales by buying an equivalent number of underlying shares
• They are given a bona fide hedging exemption (meaning, they’re exempt from limits on speculative positions) to keep the markets moving in a fair and orderly way
• Lead market makers must stand ready to both buy and sell their assigned products on a continuous basis; lead market makers also serve as a sort of “investor” for the ETF industry

ETF market makers instantly lock in their profits through arbitrage, rather than risking exposure on either side as they are attempting to hedge. This type of transaction goes on with all ETFs, and can happen with both liquid and illiquid products.

For more stories about ETFs, visit our ETF 101 category.

Tags: ETF 101