ETF Sales & Trading

Toronto | 416.869.6654Montreal | 514.394.8561

Exchange Traded Funds

Structure and Market Making

September 2014

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Mutual Fund vs. ETF Structure

Mutual Fund Market Structure ETF Market Structure

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ETF Market Making Process

1st Level of Liquidity

Primary Market

Cash or Securities In-Kind

Exchanged for ETF units

The creation and redemption process distinguishes ETFs from mutual funds and closed-end funds

ETFs track fair value due to market makers’ arbitrage potential and ability to subscribe/redeem

Three levels of liquidity: (1) Natural buyers and sellers, (2) Market Makers and High & Frequency Traders (3) Primary Market subscriptions and redemptions

2nd Level of Liquidity

3rd Level of Liquidity

Secondary Market

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ETF Arbitrage Arbitrage: The simultaneous buying and selling of an asset, or similar financial

instruments, in different markets or forms in take advantage of price differences and obtain riskless profit.

For example, if the market value of the underlying basket of stocks (on the offer side) is lower than the offer of the ETF, market makers would simultaneously buy the stocks and sell the ETF, and subsequently subscribe for the ETF by delivering the basket of stocks.

Buy Stocks

at 9.50

Sell ETF

at 9.51

Market maker has locked in 1 cent per share in riskless profit

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ETF Arbitrage continued…

Once the market maker has locked in riskless profit (i.e. 1 cent per ETF unit traded) the market maker can subscribe for newly issued ETF units by:

Delivering the underlying basket of stocks that was purchased

In exchange, taking delivery of ETF units to cover its short position

Buy Stocks

at 9.50

Sell ETF

at 9.51

Deliver underlying

Basket of Stocks

Receive ETF units in exchange for Basket of Stocks

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Automated Quoting Process

Electronic Feeds

ETF Electronic

Quotes

Fair value bid-offer is determined by underlying securities plus several other inputs

Underlying can be baskets (index, sub-index, etc.), futures (Bullion, Nat Gas, etc.), ETFs, etc.

Program’s goal is to minimize exposure, i.e. maintain a hedged position and make money

Other inputs include:Ticketing Charges, Creation/Redemption Fees, Exchange Fees, Taxes, etc.

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ETF Liquidity For stocks, supply and demand drive stock price

For ETFs, intraday supply and demand does not typically affect price; price is based on intraday fair value, which is based on the underlying index

Stock Price

ETF Price Close to Fair Value

Supply

Demand

Supply

Demand

Single Stocks ETFs

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PresenterGreg Jones, Managing Director416.869.6654 | greg.jones@nbf.ca

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