What is '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 or closed-end funds have 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 whereby 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.

  1. Creation Unit

    A creation unit is a block of new shares sold by an exchange-traded ...
  2. Premium to Net Asset Value

    Premium to net asset value (NAV) is a pricing situation that ...
  3. Index ETF

    Index ETFs are exchange-traded funds that seek to track a benchmark ...
  4. Redemption Fee

    A redemption fee is a fee charged to an investor when shares ...
  5. Redemption Suspension

    A provision on a hedge fund preventing the withdrawal from the ...
  6. Investment Fund

    An investment fund is the pooled capital of investors that enables ...
Related Articles
  1. Financial Advisor

    5 Things All Financial Advisors Should Know About ETFs

    Discover five things all financial advisors should know about ETFs, including when ETFs may be a better choice for your clients than mutual funds.
  2. Financial Advisor

    What All Investors Should Know About ETFs

    ETFs have become popular for their versatility and variety, but that doesn't mean they're always the right choice and that they're all created equal.
  3. Investing

    How ETF Arbitrage Works

    ETF arbitrage brings the market price of ETFs back in line with net asset values when divergence happens. But how does ETF arbitrage work?
  4. Financial Advisor

    The Biggest ETF Risks

    ETFs have become so popular because of the many advantages they offer. Still, investors must keep in mind that they aren't without risks.
  5. Investing

    A Look At the Growth Of the ETF Industry

    Explore the phenomenal growth rate of the ETF industry, and learn some of the principal reasons why ETFs are projected to continue to grow at a rapid pace.
  6. Investing

    When Is the Right Time to Change From Mutual Funds to ETFs

    Find out how to determine when it's the right time for you to switch from mutual funds to ETFs, including the benefits of ETFs and who they are best for.
  7. Investing

    Why Are ETF Fees Lower Than Mutual Funds?

    Discover all the reasons ETFs typically have lower fees than mutual funds, including their passive management and the absence of load and 12b-1 fees.
  1. How can I check to see if an ETF’s price reflects its asset value?

    Learn how an investor can find the net asset value for an exchange-traded fund and why the net asset value and market value ... Read Answer >>
  2. What is the difference between an ETF's net asset value (NAV) and its market price?

    Learn about the difference between the market values and net asset value of an ETF, and understand how redemption mechanisms ... Read Answer >>
  3. Do ETFs pay capital gains?

    Learn about exchange-traded funds (ETFs), which can generate capital gains for their shareholders due to occasional and substantial ... Read Answer >>
Hot Definitions
  1. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  2. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  3. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  4. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  5. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
  6. Annuity

    An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income ...
Trading Center