To understand why the ETF market is so efficient and so resilient at a time of record inflows, exploding assets, and market volatility, it’s necessary to explore a process that includes a number of market participants working together to meet investor demand.

This elaborate process involving investors, issuers, exchanges, and market makers helps produce more favorable outcomes for ETF investors by increasing liquidity and lowering costs through tighter bid-ask spreads. As ETFs continue to evolve, investors and advisors can benefit from a closer look to help them understand how these key players shape the ETF landscape and help drive efficiencies.

ETFs offer multiple layers of liquidity that benefit investors and markets. One layer is the secondary market, or the trading of ETF shares between two market participants on ETF exchanges or other trading venues. An additional layer of liquidity comes from the primary market, where ETF shares are created or redeemed in exchange for the underlying basket of securities. The primary market is what helps keep ETF prices in line with their fair value and directly influences the ETF liquidity profile that clients experience when trading ETFs in the secondary market.

To facilitate these layers of liquidity, there are a number of participants in the ETF ecosystem, including investors, issuers, exchanges, and market makers.

Investors place orders to buy and sell ETFs on exchanges and often interact with the other key players. Demand from investors helps shape the ETF products that come to market.

ETF issuers are asset management firms such as Vanguard that develop, register, and distribute ETFs. Issuer responsibilities include:

• Structuring the ETF product. This includes selecting the benchmark, setting fees, and determining the investment approach for each ETF. The way the product is structured will directly affect the transaction costs that investors pay when trading the ETF in the secondary market.
  
  
• Controlling ETF creation and redemption activity. Issuers are responsible for the process that allows new ETF shares to both enter and be removed from the market. This creation/redemption process is referred to as the primary market; it allows ETFs to trade efficiently and ensures significant liquidity for ETF investors trading in the secondary market.

There are three ETF exchanges in the United States: NYSE Arca, CBOE, and Nasdaq. In addition to providing a listing venue for ETF products, these exchanges create orderly markets by ensuring that investor limit orders (which investors use to specify a trade price) are held to the national best-bid and best-offer price. Exchanges also incentivize market makers to provide liquidity in listed ETF products, which helps ensure that there will be someone on the other side of an investor’s order to buy or sell an ETF.

ETF market makers consist of firms that provide two-sided (buy and sell) quotes in ETFs and execute investor transactions. By constantly posting orders to buy and sell ETF shares to meet investor demand, they are the primary providers of liquidity for ETFs.

Authorized participants (APs) are a type of market maker. They are financial institutions that have contracts in place with ETF issuers that enable them to create and redeem ETF shares. There is often a misconception that investors need to transact with an AP when placing large block ETF orders, because, they believe, the AP is better positioned to trade the ETF. This may not always be the case and in many instances, a market maker that is not an AP is better suited to trade a large ETF block. It’s important to consult with the issuer’s capital markets desk to understand which market makers may be better suited for large ETF trades. This decision often depends on the product type and asset class.

If demand is heavy for a particular ETF, the price of that ETF may increase slightly above its fair value. In such cases, market makers will naturally be on the other side of the trade selling ETF shares to meet investor demand. If a market maker doesn’t have enough shares in its inventory to meet client purchases, it will short or sell the ETF and look for ways to hedge risk, while contacting the ETF issuer to create new shares. This activity results in three positive developments:

• It injects new ETF supply into the market helping keep investor executions close to fair value;
• It allows market makers to minimize risk by covering their short positions; and
• It provides market makers with an arbitrage opportunity to buy the underlying basket of securities slightly below the ETF price, which helps drive competition for ETF order flow and anchors the ETF price to the true value of the fund.

The four key players of the ETF ecosystem create an interdependent framework that shapes the ETF trading experience and makes the ETF market much more liquid and efficient. Investor demand helps shape the ETF products that come to market. Issuers structure ETF products, which directly affects investor transaction costs. Market makers post quotes on exchanges to satisfy ETF investor demand and work with ETF issuers to create and redeem shares to offset their risk, driven by investor trading. The dynamic between market makers and issuers helps keep the ETF price in line with fair value through the creation and redemption process. Exchanges create an orderly market for investors to interact with market makers.

The result of this intricate process is lower costs, enhanced liquidity, and greater trading efficiencies—all of which benefit investors.