ETF Creation and Redemption Process
While ETF trading occurs on an exchange like stocks, the process by which their shares are created is significantly different. Unless a company decides to issue more shares, the supply of shares of an individual stock trading in the marketplace is finite. When demand increases for shares of an ETF, however, Authorized Participants (APs) have the ability to create additional shares on demand.
Through an "in kind" transfer mechanism, APs create ETF units in the primary market by delivering a basket of securities to the fund equal to the current holdings of the ETF. In return, they receive a large block of ETF shares (typically 50,000), which are then available for trading in the secondary market. This ETF creation and redemption process helps keep ETF supply and demand in continual balance and provides a "hidden" layer of liquidity not evident by looking at trading volumes alone.
This process also works in reverse. If an investor wants to sell a large block of shares of an ETF, even if there seems to be limited liquidity in the secondary market, APs can readily redeem a block of ETF shares by gathering enough shares of the ETF to form a creation unit and then exchanging the creation unit for the underlying securities.