ETF Creation And Redemption Models

August 17, 2012

There are two main forms of ETF creation/redemption:

  • Cash creations. A swap-based ETF can only be created when cash is delivered to the ETF provider, which in its turn will deliver the ETF units to the market maker.
  • In specie creations involve the actual delivery of a basket of financial instruments, as specified by the ETF issuer. Physically replicated ETFs can normally be created both in specie and via an exchange for cash, depending on what the investor prefers. In most cases, in specie creations are cheaper for the issuer than cash creations. However, for the market maker the costs of creating in specie are not necessarily lower as a result of the need to trade in the underlying securities.

There are several factors that need to be considered when deciding to do a creation or redemption:

  • The (minimum) creation size. Pretty much all ETFs have a minimum creation size which can be a minimum value or a minimum block size (the number of ETF units that have to be created).
  • The creation fee. The fee can be quoted in cents or in basis points (bps). Fees can be fixed or variable and can include a fixed admin fee. The fees can decrease with size for some ETFs. In particular, fixed income ETFs can have variable fees and it is also not uncommon for them to have negative fees (many fixed income indices are computed using the bid prices of the bonds, while bond ETF prices trade somewhere between the average bid and average offer prices on all the bonds in the underlying index, with this difference causing the negative fees). An important component of ETF creation fees relates to stamp duty or other transaction-based taxes in the underlying securities (such taxes are payable in the UK, France, and at the time of writing this article, soon Germany, Italy, and Spain as well).
  • The cut-off time. For many ETFs cut-off time to create/redeem is in the afternoon. After this time no creations or redemptions are accepted by the issuer. The later the cut-off time, the better for the market maker. If the cut-off is early and a trade is done after that, the position on the book has to be kept for another day. An interesting feature in the creation/redemption process of gold ETFs and ETCs is that NAV trades can take place at the AM and PM gold fixings, effectively meaning that there are two cut-off times during the day. The PM fixing is the most common, but with some ETFs it is possible to create with the AM gold fixing as well.
  • The number of APs. Some products can only be created through one AP; others can have four or five or even more. When there are more APs it is easier for investors to have access to creations and redemptions and this will therefore increase liquidity in the fund.
Figure 1
For a larger view, please click on the image above.
 

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