Plenty of Liquidity – the Beauty of ETFs .. and how it applies on BDRY
One of the beauties, among others, ETFs offer is their superior liquidity.
ETF liquidity seems to mystify investors, even professionals. Most of them would erroneously never buy an ETF because of low trading volume. While ETFs can be traded like equities, liquidity is an area in which they are nothing like equities.
Ever wonder what allows ETFs to be liquid? The answer is "creation and redemption", the process that lets ETFs trade even when volume is low.
https://www.youtube.com/watch?v=7XfyAwGbKMQ
I also found an easygoing description on wisdomtree.com: the creation/redemption mechanism allows for the increase or decrease of ETF shares based on demand without impacting other investors of the fund. If there is increasing demand for a specific ETF, new shares can be created to meet that demand in exchange for underlying assets (or cash), and if demand decreases, shares can be reduced by exchanging shares for assets (or cash). This flexible process is done solely by what is called an Authorized Participant, or AP. What is key to highlight is that the investor never makes the decision to create or redeem; that is simply a back-office function that is determined by the broker.
ETFs are traded throughout the day on exchanges. When supply and demand get out of balance, the creation/redemption process allows the authorized participant to create and redeem fund shares.
Illustrating the Life Cycle of a Trade
To illustrate how this process works, let’s follow the life cycle of a trade. In this example (still from wisdomtree.com), John Doe at Smith Capital wants to purchase 500,000 shares of a new ETF. Since the fund is new, the on-screen volume is minimal, but John knows that the ETF structure allows him to purchase shares of the ETF with efficient pricing because of the creation/redemption functionality.
ETF Creation Process
1. John goes to his broker and gives him the order to buy 500,000 shares of an ETF.
2. The broker sells the ETF shares to John at a specific price. As mentioned before, the process of buying the ETF is seamless for John the investor, and his work is done.
3. Behind the scenes on the back end, the broker has determined that, due to the increased demand by John, he as an authorized participant must create new ETF shares. He is now short the ETF shares since he sold them to John.
4. The broker then buys the basket of securities held by the ETF to hedge himself and is now long the basket and short the ETF.
5. The broker then delivers the basket of securities, or just the equal amount in cash, to the ETF issuer, initiating a creation.
6. The broker receives new ETF shares from the issuer in return and flattens out his short ETF position.
As you can see, John has nothing to do with the creation process, but the mechanism allows him to purchase a large number of ETF shares to meet his demand. This process works in reverse in terms of a redemption.
The above mechanism allows for ETFs to trade always close to fair value, or the fund’s NAV. Additionally, the creation/redemption process allows for tax efficiency, especially compared to mutual funds. Finally, the creation/redemption functionality allows an ETF to expand or contract with fluctuating client demand. The creation/redemption process can be extremely advantageous, but it is vital to remember that this is a back-office function performed by the market makers to help benefit investors.
Market Makers work with Authorized Participants (APs) to strive to keep the price of ETF shares close to fair value (i.e., in line with the ETF’s underlying net asset value (NAV)).
NYSE ticker: BDRY
For instance, ETFMG and Breakwave Advisors, for the BDRY ETF, (https://www.drybulketf.com/), have partnered with the biggest Lead Market Maker in the US for ETFs, Jane Street and some of the most experienced Authorized Participants such as Goldman Sachs, Merrill Lynch, Credit Suisse, JP Morgan, Nomura and Société Générale to help investors achieve better execution prices when trading the BDRY ETF. The Lead Market Maker is required to maintain continuous, two-sided quotes (i.e., buy and sell) on BDRY, and APs stand ready to create additional liquidity by adjusting the supply of available shares as necessary.
Size could be multiple baskets with same transaction characteristics making BDRY easier to trade for larger allocations. BDRY is one of the very few ETFs with low minimum creation/redemption basket size (25,000 shares).
Myths about ETF Liquidity
Ben Quah, Director of ETF Capital Markets at Hartford Funds, puts it nicely in his “3 myths about ETF liquidity” paper https://www.hartfordfunds.com/dam/en/docs/pub/whitepapers/ETFWP007.pdf
Myth 1: An ETF’s assets under management (AUM) and trading volume are a good proxy for its liquidity.
Fact: An ETF can have low trading volume and low AUM and still have high liquidity.
Myth 2: Secondary market ETF liquidity is limited to what you see on trading systems
Fact: Market Makers only display a small fraction of the volume they’re willing to trade.
Myth 3: It doesn’t matter when you trade an ETF
Fact: ETF pricing fluctuates during the day and could be more volatile after the market opens and before it closes.
I also find very enlightening Blackrock’s iShares video on youtube with “The Story of ETF Creation and Redemption”:
https://www.youtube.com/watch?v=A07hw-kyASs
Sources and inspiration used to write the above:
https://www.paceretfs.com/media/creation_redemption.pdf
https://www.understandetfs.org/creation_redemption.html
https://www.wisdomtree.com/blog/2017-01-17/etf-creation-redemption-process-behind-the-scenes
https://www.justetf.com/uk/news/etf/creation-redemption-the-secret-sauce-of-etfs.html