Meet the ETF Market Maker

For the everyday investor, the mechanics of buying or selling units in an ETF are pretty simple. Click to buy, click to sell. It happens almost instantly.  

But have you ever wondered why that is possible and what governs the prices you pay? 

It all comes down to market participants known as Market Makers, responsible for liquidity and pricing. So, what does that look like or even mean? 

Key Takeaways 

• A market maker for an ETF creates liquidity by quoting buy and sell prices for units and helping to maintain inventory levels to match market demand for investors on exchanges like the ASX. 
  
  
• Market makers can also act as Authorised Participants who create or redeem ETF units directly with the ETF issuer. 
  
  
• Market makers can make money from incentives paid by exchanges, along with using arbitrage opportunities on the buy-sell spread for ETF units. 
  
  

The Mechanics of ETF Trading 

Before ETF units are even available to retail investors through an exchange, like the ASX or TMX Australia Exchange, there are a few steps. 

The ETF issuer partners with an Authorised Participant (AP) to create or redeem units of an ETF in exchange for the underlying securities in the ETF or cash. The AP covers any trading costs, which allows the ETF to better track the index performance. This is considered the primary market for ETFs. 

From here, the AP will use an exchange to sell the units to investors or buy them from investors. There is usually one price to buy units, another to sell – known as the Buy-Sell spread. These prices are quoted by the Market Maker – a broker/dealer that has agreed with the ETF issuer to provide liquidity by quoting buy and sell prices for the ETF for at least 80% of trading hours.  

An AP can also be a Market Maker, or there can be a separate Market Maker. Larger ETFs may have more than one AP. Some examples in Australia include JP Morgan, Susquehanna, Jane Street and BNP Paribas.  

Market Makers coordinate with APs – if demand to buy units in an ETF is pushing its buy price above the value of its underlying holdings, they will engage the AP to create more units. If demand to sell units pushes the buy price below the value of its underlying holdings, they will engage the AP to redeem units. This helps keep prices in line with the underlying assets and ensure the units available to investors match demand. 

You can see how this looks in the flow diagram below: 

How the Market Makers Operate 

The role of the market maker is to provide buy and sell quotes to clients and keep the market trading smoothly. 

They can generate money through this in two ways: 

1. Exchanges, like the ASX, may pay market makers incentives for operating within specific requirements, like minimum time periods, minimum liquidity and a limit on the maximum spread for the buy/sell spread.  
   
   
2. Arbitrage, where a profit is made from the difference between the Buy and Sell price through trading with brokers or directing inventory back to the AP. They might also use hedging. 

To be a market maker or AP in Australia, a financial institution needs to: 

• Hold an ASIC Australian Financial Services Licence authorised specifically for these activities. 
  
  
• Be registered with an exchange. 
  
  
• Be eligible for an ASIC exemption from the naked short sale prohibition. 
  
  

Market Makers & the End Investor 

The smooth process investors know and love for buying and selling ETFs all comes back to a more complicated underlying system where market makers set the prices you pay and keep liquidity on track. They keep the secondary market (exchanges) running for ETF investors. 

While you don’t necessarily need to know or understand the market maker process to invest in ETFs, it can be valuable because market makers control your access and costs – if the spread in your ETF widens, it might not be the ETF but a delay in the market maker pulling it back in line. It can also offer reassurance if you see low trading volumes for an ETF – you don’t necessarily need to worry about liquidity in this situation because market makers will step in to provide this. 

Frequently Asked Questions 

1. What is a Market Maker? 

A Market Maker quotes buy and sell prices for ETF units and helps to maintain inventory levels to match market demand by coordinating with an Authorised Participant. This helps create liquidity and supports ETF prices remaining largely in line with the value of the underlying assets. 

2. What is the difference between a Market Maker and an Authorised Participant? 

An Authorised Participant creates or redeems ETF units directly with the ETF issuer in exchange for a basket of the underlying assets or cash. A Market Maker quotes buy and sell prices on the exchange for the available inventory created by the Authorised Participant and will coordinate with the Authorised Participant to create or redeem units to meet market demand. Authorised Participants can also be Market Makers. 

3. How do Market Makers create liquidity? 

Market Makers create liquidity by monitoring ETF unit inventory, buy-sell prices and market demand. Where market demand pushes ETF unit prices above the underlying value of assets, they coordinate with Authorised Participants to create more units and bring prices back down in line with the underlying value. When demand is low and more investors are selling units, pushing prices down, Market Makers will coordinate with Authorised Participants to redeem more units. They aim to keep the difference between Buy and Sell prices low by maintaining consistent inventory. 

4. Can an ETF with low trading volume still offer liquidity? 

Even if an ETF has low trading volume, it can still be highly liquid because Market Makers are able to create liquidity through quoting prices and working with Authorised Participants to create or redeem units. 

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.