Exchange Traded Funds Structure and Market Making September 2014

1. Exchange Traded Funds Structure and Market Making September 2014

2. Mutual Fund vs. ETF Structure Mutual Fund Market Structure ETF Market Structure

3. ETF Market Making Process • 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 1st Level of Liquidity Secondary Market 2nd Level of Liquidity Cash or Securities In-Kind Exchanged for ETF units Primary Market 3rd Level of Liquidity

4. 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. BID 9.49 OFFER 9.50 BID 9.48 OFFER 9.51 Buy Stocks at 9.50 Sell ETF at 9.51 Market maker has locked in 1 cent per share in riskless profit

5. 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

6. Automated Quoting Process • 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 ETF Electronic Quotes Electronic Feeds Other inputs include: Ticketing Charges, Creation/Redemption Fees, Exchange Fees, Taxes, etc.

7. 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 Single Stocks ETFs Supply Supply Stock Price ETF Price Close to Fair Value Demand Demand

8. Presenter Greg Jones, Managing Director 416.869.6654 |greg.jones@nbf.ca

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