What is a Redemption Mechanism
A redemption mechanism refers to how market makers of exchange traded funds (ETF) help to reconcile the differences between net asset value (NAV) and market values when shares of the ETFs trade at discounts or premiums to their NAV. ETF authorized participants use the advantages that they have through the redemption process to move ETF market prices.
BREAKING DOWN Redemption Mechanism
The redemption mechanism is a mechanism used by authorized ETF participants. It can also be referred to as the creation/redemption mechanism.
Authorized participants are broker-dealers who sell and redeem shares for ETF issuers. They partner with ETF issuers throughout the market. Authorized participants have agreements in place with ETF issuers on the number of ETF shares the issuer chooses to create and redeem. This power allows them to take advantage of arbitrage opportunities arising from discounts and premiums to ETF NAV prices. It also creates a mechanism that keeps ETF prices trading close to their accounting NAV.
Authorized participants and the redemption mechanism are unique from mutual funds or unit investment trusts. Open-end mutual funds can only be bought or sold at their NAV, which is calculated at the end of the trading day. Unit investment trusts can trade more fluidly, however the structure allows them to trade away from the NAV of the underlying portfolio. Closed-end funds are similar to unit investment trusts since they also trade throughout the day with prices that can differ from the NAV. Neither unit investment trusts nor closed-end funds has the advantage of authorized participants who can use the redemption mechanism to manage the market price.
Redemption Mechanism Trades
ETF creation units and redemption units rely on transactions that involve the underlying securities in exchange for ETF shares. If an authorized participant wants to contract with an ETF issuer for creation units of ETF shares, they will buy the underlying securities in the open market and transact them in-kind for the ETF shares in a creation unit. This can be called the creation mechanism. Similarly if an authorized participant wants to redeem shares, they do so for an in-kind transaction, receiving the underlying securities in exchange for the ETF shares. Authorized participants and ETF issuers have comprehensive access to the financial markets for transacting creation and redemption units with in-kind shares. The in-kind transaction mechanism involved with the creation and redemption of ETF shares is what keeps ETF shares trading more closely in line with their accounting NAV.