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I understand market makers of ETFs earn a bid-ask spread (buying low from investors and selling high in the market). But how exactly do they determine when's the right time to buy, and at what price?

I am super curious about their pricing model. My guesses are that they use correlation analysis of similar ETFs, NAV, and trading volume to determine the price; but I guess that's super preliminary; I am curious about the industry-standard pricing model of ETF. Feel free to correct any of my misunderstanding Thanks!

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ETF market-making has a more complex mechanism than 'regular' market-making. This answer deals explicitly with open-ended ETFs. I will refrain repeating the details about market-making that most people know that have already been asked and answered ad nauseum.

On top of traditional market-making in the secondary market in which traders trade with each other, open-ended ETFs involve what is known as an authorized participant (an AP). An AP can be a market-maker, a third party that market-makers work with or they can be large broker-dealers that act in both capacities. An AP will create and/or redeem units of the ETF's by working with the ETF sponsor in a predefined role. The create/redeem mechanism is the one by which open-ended ETFs outstanding shares change each day. This is also the mechanism that keeps the open-ended ETF within a general boundary relative to its NAV. All open-ended ETFs have multiple symbols that can be watched in real-time that disseminate all the information about them. For example, SPY is just the symbol that traders use to exchange shares of the ETF. There are also several other symbols that can be monitored if one were curious. SPY's NAV can be watched with ticker SPY.NV, SPY's intraday value can be watched with ticker SPY.IV. There are also symbols for SPY's shares outstanding and total cash per creation unit. These symbols will vary depending on the data provider. The SPY.NV, SPY.IV relationship to the general symbol SPY will tell you how active the AP's are and how much supply or demand there is outside of the secondary markets.

If an ETF is trading at a premium or discount to it NAV, it represents an arbitrage opportunity for someone to buy or sell the underlying components, tender them to the AP in order to create or redeem a unit, and then buy or sell said unit to lock in the arbitrage. Individual investors and hedge funds can establish relationships with prime brokers that can act in both capacities enabling them to buy, sell, and sell short large amounts of ETF shares without moving a market much at all.

BUY example: If I am a hedge fund that wants to buy 1 million shares of an ETF, I could ask my broker to create the units for me. They would buy shares of the underlying components, submit those shares to the sponsor, and dump the newly created ETF shares into my account. Depending on the nature of the relationship one has with a broker, they may do this for a flat fee or some other type of fee structure.

SHORT example: The creation mechanism also allows large traders or hedge funds to sell short ETF shares that didn't previously exist. The AP will create a unit of the ETF (say 50k shares to a unit), delta hedge it internally to offset the firms exposure and loan the new ETF shares to a client. They make money by charging a borrowing fee for the service that exceeds their cost of creating the ETF unit and maintaining the delta neutral position. The borrowing fee can change daily to allow the AP to maintain their desired profit margin.

There is a bit more to understanding how AP's play a role in making markets with open-ended ETFs. I have added some references below for you to read through. What I have described here is a somewhat high level explanation.

References:

Open-Ended ETFs vs. Closed-End Funds vs. Open-ended Mutual Funds

Understanding Exchange-Traded Funds: How ETFs Work

Authorized Participant

A Primer on ETF Primary Trading and the Role of Authorized Participants

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  • $\begingroup$ Hi @amdopt; thanks so much. "that can act in both capacities enabling them to buy, sell, and sell short large amounts of ETF shares without moving a market much at all." I assume this is the core value of an AP; say I am an investor if I want to buy 1 million SPY at price $10; but the available SPY at $10 is only 100,000. That means I "HAVE TO" rely on AP to get the shares. $\endgroup$ – Leopardl Jul 20 at 2:08
  • $\begingroup$ Follow-up Questions: Question 1: Not just the investor, but AP also makes profits from arbitrage I believe? (Given that they monitor the price so closely and got the capability to create/redeem). I did not find any rules stopping APs from using arbitrage strategies. $\endgroup$ – Leopardl Jul 20 at 2:12
  • $\begingroup$ @Leopardl if you were an everyday investor and wanted to buy 1M shares and went to the secondary market, you may drive the price above it's NAV and IV and cause an arbitrage situation that would usher APs in to create a unit and give those shares to you. In this way, the AP is already acting without you even knowing. However, if you have a relationship with one, you may get a better price. $\endgroup$ – amdopt Jul 20 at 10:49
  • $\begingroup$ Yes, nothing stops them from making profits from an arb. The arb is what keeps the APs in the game! The 'create-to-lend' profits are secondary and I only used it as an example to help you the possibilities and power behind the mechanism. $\endgroup$ – amdopt Jul 20 at 10:51
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    $\begingroup$ Got it. Thanks so much. Your detailed explanation is awesome. I also found this doc useful. hkex.com.hk/Products/Listed-Derivatives/Market-Maker-Program/… It details the incentive scheme and how they actually work.(Tho it's for HK market only). Cheers @amdopt $\endgroup$ – Leopardl Jul 20 at 13:48

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