Why ETF Market Makers Don't Always Create or Redeem Shares

Why Market Makers Don’t Always Redeem ETF Shares

Consider an ETF that trades approximately 60,000 shares per day and has consistent buying interest from investors.

A customer sells 50,000 shares, and a market maker purchases them.

Does the market maker immediately redeem those shares?

Not necessarily.

If the market maker expects continued investor demand, it may be more economical to hold the shares in inventory and gradually sell them to buyers in the secondary market. Redeeming immediately would involve transaction fees, delivering ETF shares, receiving the underlying basket or cash proceeds, and potentially liquidating securities that the firm would otherwise prefer not to own.

This illustrates an important point about ETF liquidity: The ability to create or redeem shares doesn't mean doing so is always the most economical decision.

Market Making Is an Inventory Business

ETF market makers continuously balance customer demand, hedging costs, financing arrangements, and inventory levels.

When a market maker purchases ETF shares from a seller, those shares don't necessarily need to be redeemed. They may be sold to another customer later that day or over subsequent trading sessions.

Similarly, when a market maker sells ETF shares short, it doesn't automatically need to create new shares. It may maintain the short position temporarily, hedge the exposure, borrow shares to meet delivery obligations, or wait for offsetting customer selling.

The decision depends on the economics of the position and the firm's expectations for future trading activity.

Why Market Makers Don't Always Create Immediately

Consider an ETF trading at $25 per share with a creation-unit size of 25,000 shares.

A market maker sells 40,000 shares short, representing a $1 million position.

The firm could create two units, receiving 50,000 ETF shares, covering its short position, and leaving itself long 10,000 shares.

In many circumstances, carrying a 10,000-share long position is preferable to maintaining a 40,000-share short position.

But the economics also depend on how the market maker is hedged.

If the firm owns the underlying securities, it may already have much of the basket required for creation. If it is hedging with index futures or another ETF, creating shares could require purchasing the underlying securities and unwinding an otherwise efficient hedge.

Creation fees, financing costs, and anticipated customer flow all influence the decision.

The question isn't simply whether the market maker can create shares. It's whether creating now produces a better economic outcome than the alternatives.

Fixed Fees Can Influence Creation and Redemption Activity

Another important consideration is the structure of creation and redemption fees.

Many ETFs charge a fixed transaction fee for creation or redemption orders, sometimes alongside variable fees designed to address transaction-related costs.

When a fixed fee applies per order, creating or redeeming multiple units in a single transaction can reduce the fixed cost per share.

For example, assuming a $500 fixed creation fee, a 25,000-share creation would incur a fixed cost of two cents per share. Creating 100,000 shares in a single order would reduce that cost to half a cent per share.

This can give market makers an economic incentive to accumulate larger positions before creating or redeeming, rather than submitting multiple smaller orders.

Of course, waiting also carries costs. Financing, hedging expenses, market risk, and settlement obligations must be weighed against the potential savings.

Variable transaction fees, which generally increase with transaction size, don't offer the same economies of scale.

Settlement Timing and Financing Matter

Timing can also influence the decision.

Suppose a market maker needs ETF shares for a Friday delivery obligation. An eligible creation submitted Thursday would generally settle Friday under the standard T+1 cycle. Waiting until Friday could require a same-day creation, borrowing shares, or another permissible arrangement to meet that obligation.

Financing and stock-borrow expenses can also accrue over weekends and holidays.

However, creating or redeeming doesn't necessarily eliminate financing costs. It may replace one financed position with another.

Market makers therefore compare the incremental costs of accessing the primary market against maintaining inventory and hedges.

More ETFs, Greater Focus on Capital Efficiency

As the ETF universe expands, market makers have more opportunities across products with different trading patterns, underlying securities, hedging instruments, and creation and redemption costs.

This doesn't necessarily mean market-making capital is scarce. It means firms must continually evaluate how efficiently they deploy their capital, financing, and credit capacity.

A market maker might create shares in one ETF, maintain a short position in another, and hold long inventory in a third, expecting to sell those shares to future buyers.

Each decision reflects the economics of that particular position.

For ETF issuers, these dynamics highlight the importance of creation-unit sizing, basket construction, transaction fees, reliable settlement procedures, and efficient hedging opportunities.

Consistent secondary-market buying and selling interest can also help market makers manage inventory without repeatedly accessing the primary market.

The Bottom Line

The creation and redemption mechanism is fundamental to the ETF structure, but it isn't designed to be used after every secondary-market transaction.

Market makers aren't paid to create or redeem ETF shares. They're in the business of providing liquidity profitably.

Sometimes that means accessing the primary market. Other times, the most efficient trade is the one that never results in a creation or redemption.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.