Education Corner


ETFs: Understanding primary and secondary markets

APs and market makers play a crucial role

Education corner / Trading / ETFs: Understanding primary and secondary markets


ETFs differ from other investment vehicles because they trade on both the primary and secondary markets. 

In broad terms, the primary market is where ETF shares are created and redeemed while the secondary market is where they are traded among investors. 

Authorised participants (APs) are responsible for creating and redeeming ETF shares in the primary market by engaging with issuers directly. 

Primary market activity is vital for maintaining an ETF’s alignment with its underlying assets, or the ETF's net asset value (NAV). 

Primary market

The creation-redemption mechanism ensures an ETF’s shares trade at a price close to its NAV. 

When an ETF’s shares trade at a premium – higher than its NAV – APs can profit by purchasing the underlying assets, exchanging them for new ETF shares in the primary market, and selling those shares in the secondary market. 

Conversely, if ETF shares trade at a discount – lower than its NAV – APs can buy the undervalued ETF shares, redeem them for the underlying assets in the primary market and sell them for a profit. This helps to keep the ETF's market price in line with its NAV. 

Secondary market

The secondary market is where ETF shares are exchanged among buyers and sellers after they have been issued in the primary market.

In the secondary market, investors exchange previously issued ETF shares without the issuing companies’ involvement.

This is the market most investors are familiar with, operating through major stock exchanges like the London Stock Exchange (LSE) or Deutsche Boerse.

The secondary market provides an extra layer of liquidity for ETFs by allowing market makers to match buyers and sellers throughout the trading day without impacting the primary market.

Market makers and liquidity

Through operating in both the primary and secondary markets, ETFs are unique to other fund structures. Mutual funds only operate in the primary market and therefore trade once a day at the closing NAV while investment trusts only trade in the secondary market.

The continuous pricing of ETFs offers investors the advantage of responding promptly to market movements.

Finally, ETFs have a bid-ask spread which reflects the costs the authorised participants (APs) pay in the primary market to create and redeem the ETF.

This spread is the difference between the highest price a buyer is ready to pay and the lowest price a seller is willing to accept.

ETFs tracking more illiquid assets have wider bid-ask spreads while popular indices such as the S&P 500 will trade at tighter bid-ask spreads.

Overall, the primary market’s creation-redemption processes and the secondary market's trading dynamics put ETFs at a significant advantage over other fund structures.

Key takeaways

  • In the primary market, authorised participants (APs) directly interact with ETF issuers to create and redeem shares, ensuring that ETF prices remain aligned with their underlying net asset value (NAV). This mechanism allows ETFs to maintain a balance between the shares available and the underlying securities, facilitating accurate pricing.

  • The secondary market provides liquidity and flexibility for ETF investors, allowing them to buy and sell shares throughout the trading day on major stock exchanges

  • ETFs operate across both primary and secondary markets, differentiating them from mutual funds and investment trusts

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