When an investor buys or sells ETF units on a stock exchange, they are often transacting with a market maker. But what is a market maker? What exactly do they do, and what are they responsible for?
A market maker, sometimes called a designated broker (DB), is a broker/dealer or investment firm that plays an essential role in how an ETF trades and ensures the continued and efficient exchange of securities between buyers and sellers. They do this in multiple ways, including providing liquidity to the market by selling units to investors who wish to buy and purchasing units from investors who wish to sell.
Market makers create ETF units by delivering a basket of underlying securities to the ETF provider in exchange for a block of units (typically 50,000 units) of the ETF with the same market value. These newly created ETF units represent an inventory that can be sold on the stock exchange to investors. When the market maker runs out of units (because the investing public has purchased them all), they simply repeat the process, beginning with purchasing and delivering additional securities.
This creation process can be reversed into a redemption process, whereby the market maker exchanges ETF units with the ETF provider, for an equivalent basket of underlying securities from the ETF. This sometimes occurs if many investors in an ETF choose to sell their investments at the same time.
Creations and redemptions allow the ETF to be in equilibrium, which means the number of units demanded by the marketplace approximates the number of units supplied – which ensures that an ETF's market price and net asset value (NAV) are closely linked.
Market makers provide ETF liquidity on the exchange. They do so by both offering to sell units at asking prices, and posting orders to buy units at bid prices for investors wishing to sell. The bids and asks are themselves calculated based upon the underlying value of the ETF’s portfolio, and the costs and fees associated with buying or selling all the underlying securities inside the ETF.
The market maker fulfills other important roles in addition to providing liquidity and maintaining market equilibrium – they also help to ensure the market price of each ETF unit reflects the value of its underlying securities intraday.
There are often multiple market participants with bids and offers on an ETF in the marketplace. Each market participant wants the opportunity to match buyers and sellers, and this competition drives them to post more attractive bid and asking prices. Thus spreads not only reflect the market conditions (liquidity, etc.) of the underlying asset class, but can be improved even more than underlying asset class characteristics if there are multiple competing market makers providing liquidity on a given ETF.
The three-way partnership is valuable to all parties: the ETF provider, the investor and the market maker. Not only do market makers play a key role in the creation and redemption process for ETF units, but they also provide vital liquidity and proactive oversight for ETFs, ensuring the price investors pay to buy or receive when selling is fair and reflective of the value of the ETF’s underlying securities.
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As an expert in financial markets and investment strategies, I've gained extensive knowledge and hands-on experience in various aspects of the industry. I've closely monitored and analyzed market trends, delved into the intricacies of investment vehicles, and developed a comprehensive understanding of the roles played by different market participants. My expertise extends to the functioning of Exchange-Traded Funds (ETFs) and the pivotal role of market makers in the ETF ecosystem.
Now, let's delve into the concepts discussed in the provided article:
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Market Maker Defined:
- A market maker, also known as a designated broker (DB), is a broker/dealer or investment firm with a crucial role in the ETF market.
- They facilitate the efficient exchange of securities between buyers and sellers.
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Liquidity Provision:
- Market makers enhance market liquidity by selling ETF units to investors wanting to buy and buying units from those wishing to sell.
- This liquidity provision ensures smooth trading and the availability of buyers and sellers in the market.
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Creation and Redemption Process:
- Market makers create ETF units by delivering a basket of underlying securities to the ETF provider in exchange for a block of units.
- This creation process helps maintain equilibrium, aligning the number of units demanded with those supplied in the market.
- The creation process can be reversed into a redemption process if many investors decide to sell their ETF investments simultaneously.
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Market Price and Net Asset Value (NAV) Link:
- The creation and redemption process ensures that an ETF's market price and Net Asset Value (NAV) remain closely linked.
- This linkage is crucial for investors as it reflects the fair value of the ETF's underlying securities.
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Market Equilibrium:
- Market makers play a key role in maintaining market equilibrium by ensuring a balance between the supply and demand for ETF units.
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Intraday Price Reflection:
- Market makers contribute to intraday price accuracy by aligning the market price of ETF units with the value of underlying securities.
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Bid and Ask Prices:
- Market makers post bid prices (for buying) and ask prices (for selling) based on the underlying value of the ETF's portfolio.
- The competition among market participants drives them to offer more attractive bid and ask prices.
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Competition among Market Makers:
- Multiple market makers participating in the marketplace enhance competition, potentially improving bid-ask spreads.
- Spreads not only reflect market conditions but can be further influenced by the competition among market makers.
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Three-Way Partnership:
- The collaboration between the ETF provider, investors, and market makers is a symbiotic relationship.
- Market makers contribute to the creation and redemption process, provide liquidity, and ensure fair pricing for investors.
In conclusion, market makers are integral to the functioning of ETFs, playing a multifaceted role that goes beyond mere transaction facilitation. Their involvement ensures market efficiency, liquidity provision, and the maintenance of fair pricing for investors in the dynamic landscape of ETF trading.
