Despite explosive growth in the use of exchange-traded funds (ETFs) in the last decade, a few persistent myths about them remain. On our ETF capital markets desk, for example, we often hear from advisors with liquidity concerns. The idea that volume equals liquidity persists among many investors, and advisors get a lot of questions about this from their clients. Let’s dispel this myth by looking a little deeper at the role of the market maker in ETF trading.
Market makers: The anatomy of a trade
Let’s say Joe Investor wants to buy $1 million in units of an ETF, but the ETF shows low trading volume and low asset size. The “volume equals liquidity” myth would have him believe that the trade would be problematic, but he places the trade and the transaction is completed without issue. Joe Investor’s experience is due to the important, yet generally invisible, role of the market maker.
When an investor wants to buy or sell units of an ETF, they can transact with other buyers and sellers in the natural marketplace – retail or institutional investors. But at times when there is an imbalance – say, too many buyers– a market maker can create units using an in-kind transfer (see the graphic below). It is the liquidity of the underlying securities – not the trading volume of ETF units – that determines the liquidity of the ETF. A market maker can access the liquidity of the underlying holdings via the creation/redemption process. The market maker creates units by purchasing baskets of the ETF’s underlying holdings, which allows the ETF provider (i.e., PowerShares) to create new units for the buyer who has placed the trade. This process allows for large trades to be executed with precision and efficiency. Just as importantly, market makers can also act as a buyer when an investor is looking to sell units of an ETF. They can also utilize the redemption process for any large sell orders.
For illustrative purposes only.
In our example above, Joe Investor transacted with a market maker, but may not have been aware of the behind-the-scenes work the market maker did to ensure the smooth transaction.
Who is a market maker?
The market maker role is taken on by a broker, dealer or investment firm. In Canada, the five largest ETF market makers are affiliated with the major banks, but there are also other players in the space that are not household names.
How it works
Market makers don’t want to take on traditional investment risk or hold stock positions to make a return. Their role is only to provide liquidity throughout the trading day for investors who want to buy or sell ETF shares. To do this, they post ETF units for sale near or at the current ask price, and units for purchase near or at the current bid price. Market makers calculate their prices based on the respective bid and ask of the underlying securities held by the ETF, plus any trading costs or fees. They take on only short-term positions, and hedge this position as best they can.
Let’s go back to Joe Investor’s $1 million trade. The trade is complete and the market maker is now in a short position of $1 million of the ETF. To offset this, the market maker will hedge the transaction with a long position, which creates risk. Generally, the more risk a market maker is taking on (based on availability of the underlying securities, ability to hedge and overall market conditions, among other things), the greater the spread between the bid price and the ask price. The market maker is compensated for taking on this risk through the bid/ask spread, net of transaction costs.
What does it mean for you?
Market makers play a key role in ETF trading – they provide liquidity, help maintain ETF-market stability and ensure that ETF pricing reflects the value of the underlying securities. While much of the work occurs in the background, it is important for investors to understand how the process works to get the most out of their ETF trades.
Here at PowerShares, our Capital Markets trading desk works directly with different market makers to assess their effectiveness in making markets for our ETF lineup. These relationships allow us to support our clients with their ETF trades. We are available to advisors for trading and liquidity guidance on ETF trades.
To get in touch with our ETF Capital Markets team, please contact your PowerShares Sales rep at 1.800.261.8689 or e-mail us at firstname.lastname@example.org.