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Exchange Traded Funds Structure and Market Making September 2014. Mutual Fund vs. ETF Structure. Mutual Fund Market Structure. ETF Market Structure. ETF Market Making Process. The creation and redemption process distinguishes ETFs from mutual funds and closed-end funds

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Presentation Transcript
Exchange Traded Funds

Structure and Market Making

September 2014

mutual fund vs etf structure
Mutual Fund vs. ETF Structure

Mutual Fund Market Structure

ETF Market Structure

etf market making process
ETF Market Making Process
  • The creation and redemption process distinguishes ETFs from mutual funds and closed-end funds
  • ETFs track fair value due to market makers’ arbitrage potential and ability to subscribe/redeem
  • Three levels of liquidity: (1) Natural buyers and sellers, (2) Market Makers and High & Frequency Traders (3) Primary Market subscriptions and redemptions

1st Level of Liquidity

Secondary Market

2nd Level of Liquidity

Cash or Securities In-Kind

Exchanged for ETF units

Primary Market

3rd Level of Liquidity

etf arbitrage
ETF Arbitrage
  • Arbitrage: The simultaneous buying and selling of an asset, or similar financial instruments, in different markets or forms in take advantage of price differences and obtain riskless profit.
  • For example, if the market value of the underlying basket of stocks (on the offer side) is lower than the offer of the ETF, market makers would simultaneously buy the stocks and sell the ETF, and subsequently subscribe for the ETF by delivering the basket of stocks.









Buy Stocks

at 9.50

Sell ETF

at 9.51

Market maker has locked in 1 cent per share in riskless profit

etf arbitrage continued
ETF Arbitrage continued…
  • Once the market maker has locked in riskless profit (i.e. 1 cent per ETF unit traded) the market maker can subscribe for newly issued ETF units by:
    • Delivering the underlying basket of stocks that was purchased
    • In exchange, taking delivery of ETF units to cover its short position

Buy Stocks

at 9.50

Sell ETF

at 9.51

Deliver underlying Basket of Stocks

Receive ETF units in exchange for Basket of Stocks

automated quoting process
Automated Quoting Process
  • Fair value bid-offer is determined by underlying securities plus several other inputs
  • Underlying can be baskets (index, sub-index, etc.), futures (Bullion, Nat Gas, etc.), ETFs, etc.
  • Program’s goal is to minimize exposure, i.e. maintain a hedged position and make money

ETF Electronic Quotes

Electronic Feeds

Other inputs include:

Ticketing Charges, Creation/Redemption Fees, Exchange Fees, Taxes, etc.

etf liquidity
ETF Liquidity
  • For stocks, supply and demand drive stock price
  • For ETFs, intraday supply and demand does not typically affect price; price is based on intraday fair value, which is based on the underlying index

Single Stocks




Stock Price

ETF Price Close to Fair Value




Greg Jones, Managing Director

416.869.6654 |[email protected]


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