A liquidity provider can facility ETF buy and sell orders that comes through exchanges, providing liquidity on both sides of the market for the duration of a trading session. The liquidity provider sells to the market as an investor wants to buy an ETF. The liquidity provider will go long the underlying stocks that make the ETF why going short the ETF to hedge his position.
Once demand for an ETF reaches the size of a creation unit, or about 50,000 shares, a liquidity provider can put in an order for a unit to an Authorized Participant who will go to the actual ETF issuer to exchange the in-kind portfolio of component securities for a creation unit of the ETF, relieving the short ETF position.
For sell orders, the liquidity provider buys ETFs from the public and sells short the basket of underlying securities. If enough orders are processed to hit a creation unit, the liquidity provider can submit an order to redeem his position of 50,000 shares in an ETF through an Authorized participant.
However, there are some exceptions. For instance, some exchange traded note providers have halted new share issuance before, which have caused the investments to trade at a steep premium or discount to their net asset value.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.