ETFs are considered highly liquid, even if their order book shows little trading. The interaction between stock exchange trading and the mechanism for creating new shares makes purchases and sales possible at almost any time.
• Two markets, one goal: ETF liquidity is created on the stock exchange and in the background via creation and redemption
• Market makers and authorized participants keep prices stable and enable large orders
• During periods of stress, ETFs remain tradable, even if premiums or discounts occur
Why ETF liquidity is more than visible trading volume
The liquidity of exchange traded funds is often measured by the visible trading volume. But this impression falls short. A report from Deutsche Börse shows that the real liquidity potential of an ETF is significantly greater than what investors see in the order book.
The secondary market only forms the first layer of tradability. Market participants such as private investors can buy or sell ETF shares without the ETF provider being involved.
According to ETF Stream, this creates a decisive advantage: ETFs can also access a second market – the primary market. ETF shares are created or redeemed there. This means that even products with low visible volume are often significantly more liquid than many investors assume.
The primary market: Creation and redemption as a liquidity engine
The backbone of ETF trading is the primary market. According to extraETF, the creation-redemption process allows outstanding shares to be flexibly adjusted to demand. Authorized participants exchange baskets of securities for ETF shares or vice versa. This process is invisible to private investors, but forms the basis for large orders to be processed without price distortion.
The NASDAQ provides an example: If a market maker needs to deliver more shares than are available in the secondary market, it can create new ETF shares with the help of an authorized participant. This means that the ETF remains tradable and its price is closely aligned to the net asset value.
The Secondary Market: Where Investors Actually Trade
The secondary market plays a central role, especially for investors. Here, ETF shares are traded like shares on stock exchanges. According to Deutsche Börse, market makers and so-called designated sponsors provide buy and sell prices and calculate them based on the current composition of the ETF.
The basis for this is the daily portfolio composition files, in which the provider publishes the exact weighting of the titles included. ETF Stream describes market makers as a link between both markets. They balance supply and demand and ensure that the bid-ask spread, i.e. the spread, remains appropriate.
In turbulent phases: NAV deviations, spreads and the “illusion of liquidity”
The ETF structure comes into focus, particularly in stressful phases. ETF Stream reports that in March 2020, many bond ETFs were trading at significant discounts to their net asset values because liquidity dried up in the bond market. However, these deviations are an expression of market reality and not a weakness of the ETF structure.
According to Deutsche Börse, market makers can provide prices even in volatile phases as long as the underlying market remains at least partially functional. If the liquidity of the underlying assets is completely lost, authorized participants can no longer operate on the primary market for a time. The ETFs will then continue to be tradable on the secondary market, albeit at wider spreads. Compared to classic funds, which have to suspend redemptions in such situations, ETFs offer investors a greater degree of flexibility.
Editorial team finanzen.net