ETF bid/ask spread [duplicate]

Question

I was just wondering if someone could explain to me how an ETF market maker earns profit through the spread they collect while hedging the positions to be non-directional.

For example I read somewhere that: Say that ETF market maker buys ETF at bid and hedges that by shorting the basket. He then manages to offload that long position by selling at ask and flattening the hedge. From what I understand, the trader's profit = (spread earned) - (spread paid for hedge). Can someone confirm that this logic is correct? I was just wondering how this would be practical given that the basket might contain many other stocks and the trader would have to purchase all the underlying stocks of the ETF?

I was also wondering whether the creation and redemption mechanism has anything to do with the ETF market maker's operations. So back to the example above, instead of offloading the long position by selling to the trader. Is there a way to use the creation redemption mechanism to capture the bid/ask spread and to flatten the hedge? Perhaps he could redeem the ETF to obtain the underlying basket and flatten the hedge but how does he capture the bid/ask spread then?

I would appreciate if anyone could help me out with this! Thank you.

Answer 1

Your question has two parts (at least to me):

1. How do you make money hedging ETF market making vs some other product?
2. How do deal with the resulting positions?

For #1, a very similar question was asked about the trading process just recently. See here for details: ETF Market Making - Locking profits via hedging

For #2, here's the problem. Let's say you lock in a good position - you buy the future for a bit less than you sell the equivalent ETF. But now you have a position - when will you realize this p/l instead of just holding securities on your balance sheet?

You really have two choices:

1. Hope the market gives you a chance to reverse the trade at a profit. Downside: You are using your firm's collateral to hold this trade until then. Let's say you trade \$100m of SPY vs \$100m of futures to earn 20bps. That's great, \$200k of p/l. But if it takes three months to unwind the trade then you have just earned \$200k on \$200mm dollars over 3months - or 1.2% anualized. And most market-makers use margin and leverage and are getting charged every day on top of this.
2. Create / redeem. With the redemption/creation process you turn in the ETF to the custodian (or the stock basket) and get back the underlying stocks (or get a new ETF). This might reduce your position. But, you have to consider in this case that the custodian charges a fee (\$3k for SPY) - and you have to post collateral in the interrim, which can also cost you.

So even if you can achieve perfect arbitrage, you still have friction. The create/redeem process is one technique of dealing with it - but that's not frictionless either!.