Unlike equities, ETF trading is heavily influenced by institutional brokers/investors referred to as authorised participants (APs) or market makers. Though these two terms are sometimes used interchangeably, they have distinct functions.
APs manage the creation and redemption of ETF units in the primary market, leading to ETF flows, specifically the increase or decrease of ETF units on issue, as determined by investor supply and demand. It is a process critical to ETFs trading at parity with NAV.
Market makers, on the other hand, provide price and volume quotes to buyers and sellers of ETFs. Their primary role is to provide liquidity and ensure efficient trading on the secondary market. Market makers seek to generate a profit based on a small arbitrage margin between the price at which the ETF is transacted and the underlying value of the securities that represent the ETF portfolio (the NAV of the ETF).
That margin represents the bid-ask spread. For example, if a market maker is present in the market as a buyer, it will offer a bid price that is marginally below the NAV of the ETF (the bid spread). Assuming the market maker is ‘hit’, i.e. there is not an investor offering a higher bid price, the market maker sells the individual shares with the intent of making a marginal arbitrage profit.
A market maker may also be contracted to maintain a maximum spread. If the market maker is not contracted in this regard, it is still bound by ASX rules in relation to maximum spreads (but these are quite wide) and by minimum bid and ask volume offers. The benefit of a contracted bid-ask spread is it better ensures an ETF remains competitive with other ETFs. Investors should be aware that in periods of heightened volatility, spreads are likely to blow out if there isn’t a contracted bid-ask spread. All ETFs must have at least one market maker unless the ETF has more than 1,000 investors and the issuer is confident spreads will remain tight (i.e., there is sufficient trading volume).