Creation and redemption is a process of making and destroying ETFs according to their demand. You can understand the supply and demand process of an ETF with an example of close ended fund. A basic difference between ETFs and closed-ended funds is their reaction to supply and demand in the market.
In the case of closed-ended funds the supply cannot be increased with demand, there are a fixed number of the fund’s units that trade on any exchange. So that means a closed-ended fund trades at premiums in high demand– where the fund costs more to buy than the value of its holdings. But supply of a close ended fund cannot be decreased when demand falls, meaning that the fund can be on discount in low demand.
But ETFs have a magical power of “creation and redemption” to change their supply as demand rises and falls. It also allows ETFs to ensure they are priced fairly even as investor demand swings wildly.
Liquidity in ETF Liquidity in ETF can be easily created by APs . APs are pre appointed by AMCs to provide ETF liquidity in market. APs are basically middle men who help in creation and redemption of ETF to enhance ETF liquidity.
So take a tour to understand, how does it work?
There are many participants are involved in making of an ETF called “authorized participants,” (AP). Generally APs are big firms like bank and are pre appointed by AMCs. APs are decide how many ETFs get made and destroyed working closely with ETF providers to make a market for an ETF.
How APs create ETFs.
If an investor want to buy ETF he can buy through a broker. But if there is not enough people who want to sell particular ETF which he want to buy. To solve this, more ETFs can be created instantly to fulfill order. In this scenario Authorized participants purchase all the stocks that are present in ETF and gives to AMC, now AMC creates ETF and gives to APs and then APs deliver it to exchange or broker. This process is called ETF creation. This ‘creation’ mechanism ensures that there are always enough ETFs to go around, and that they never really have to trade at premiums in high demand.
Redemption If an investor wants to sell some ETFs but there are not enough buyers for ETFs. In this type of scenario the close ended funds trade at low cost but in the case of ETFs this is no problem as they can be redeemed and destroyed. In this situation Aps bring the ETFs to the ETF provider and ‘redeem’ them for shares. ETF redemption is also an automatic process like ETF creation.
Creation and Redemption is the “secret sauce” that makes ETFs less expensive, more transparent and more tax efficient than traditional mutual funds.