ETFs are continuing to grow in popularity, which is awesome.

Also means it’s important to understand the basic dynamics:

1) You submit an order to buy 100 shares of an ETF, ticker ‘ABC’. If there is a “natural” seller (i.e. an ABC shareholder that is willing to sell), your trade is executed.

You buy 100 shares of ABC from the “natural” seller. The trade is complete.

2) However, there isn’t always a “natural seller.” Instead, you submit an order to buy 100 shares of ABC.

In this scenario, a market maker steps in to make you a price.

You buy 100 shares of ABC from the market maker.

3) The market maker may have sold existing inventory from its balance sheet.

More likely, however, is that the market maker didn’t own any shares of ABC before the trade. Instead, they borrowed 100 shares of ABC to sell to you.

The market maker is now short 100 shares of ABC.

4) The market maker doesn’t want to take price risk. As a result, simultaneous to shorting 100 shares of ABC, the market maker buys 100 shares worth of the underlying basket.

The market maker is now long 100 shares worth of the underlying ABC basket, and short 100 shares of ABC.

5) The market maker repeats this process over and over until they have accumulated a large short position in ABC and a large long position in the underlying ABC basket components.

6) Once the value of their hedged traded reaches the size of one creation unit (i.e. 50,000 ETF shares worth), the market maker places a trade via an Authorized Participant (“AP”) to “create” new shares of the ABC ETF.

7) In order to do so, the AP delivers 50,000 shares worth of the underlying ABC components to the ETF trust, which in turn issues 50,000 “newly created” shares of ABC.

8) As a result, the market maker is no longer long the underlying ABC components (those shares were delivered to ETF trust). Nor are they short shares of ABC (newly created ETF shares have offset their previous short position).

This is called the in-kind creation process.