ETFs undergo a creation and redemption process in which market makers, authorized participants or large institutional investors swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa.
The creation and redemption process helps keep an ETF trading near its NAV and allows large traders to go in and out of what appears to be an ETF with low liquidity. For instance, if an advisor or investor is interested in taking a large order on an ETF that only trades on a couple thousand shares per day, he or she would contact a broker or authorized participant. Behind the scenes, the AP would tap into the underlying benchmark to acquire the necessary liquidity to back the large ETF trade. [How ETFs Are Traded]
The potential changes to the creation and redemption rules would also help address growing liquidity concerns about the underlying bond markets. As banks and institutions hoard fixed-income securities, investors have turned to bond ETFs in response to the lack of liquidity across the underlying markets, potentially setting the stage for liquidity problems if ETFs experience large redemptions during a major sell-off. [Liquidity Concerns in Corporate Bond ETFs]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.
