Trading At The Margin
Exchange-traded funds work by engaging specialised intermediaries (so-called "authorised participants" or "APs"
to exchange the shares or bonds in an ETF's underlying index for the ETF shares themselves. Such "creations" of ETF shares take place in standardised units, often worth a few million dollars each. When the AP returns ETF shares to the issuer in the reverse process, a redemption, he receives the index shares or bonds, leaving him where he started.
For a liquid equity ETF, the constituents and constituent weightings of the creation "basket" supplied by the AP to the ETF issuer are pretty much identical to those of the index itself. Look into the creation basket of an S&P 500 or Euro STOXX 50 ETF, and you'd see the index in microcosm, in other words.
But for ETFs tracking less liquid indices or asset classes, the creation and redemption process has never been that simple.
"When we wanted to create a unit of iShares' MSCI World ETF in the early 2000s, we had consistent problems delivering the less liquid 'tail' of index stocks, and this regularly caused the whole creation process to fail," one former ETF trader told IndexUniverse.eu on condition of anonymity.
The MSCI World index contains around 6,000 stocks from 24 countries.
"The penalty for a failed settlement on a large stock basket was US$30 per stock, and that's before counting the funding costs for delayed settlement and potential buy-in penalties levied by clearing systems. As a result it was extremely expensive to fail an ETF creation. So we worked with iShares to develop a new methodology:cash creation," said the trader.
Read more: http://community.nasdaq.com/News/2012-10/trading-at-the-margin.aspx?storyid=179621#ixzz28Ty0JMc2