Know your ETFs: The primary and secondary markets

ETFs operate within a unique ecosystem supported by authorized participants, market makers, custodians, and pricing agents. Their dual-market structure – comprising the primary market, where authorized participants create or redeem shares, and the secondary market, where investors trade shares on exchanges – enables flexible supply adjustments, real-time pricing, and intraday liquidity.

This interplay distinguishes ETFs from other investment products, offering continuous liquidity and prices closely tied to their underlying assets, making them flexible and accessible for a broad range of investors.

Two markets, one fund

ETFs function simultaneously in two distinct markets:

Most investors only interact with the secondary market – placing trades through a brokerage account just as they would for individual stocks. But the primary market is where the real structural innovation occurs, allowing ETF share supply to expand or contract based on demand.

The secondary market

Where investors trade

The secondary market is the public stock exchange – such as the New York Stock Exchange or Nasdaq – where ETF shares change hands between buyers and sellers throughout the trading day. Prices fluctuate based on supply and demand, moving up when more investors want to buy and down when more want to sell.

Secondary market trading is continuous. An ETF's price updates in real time, allowing investors to enter or exit positions at any point during market hours. This intraday liquidity is one of the primary advantages ETFs offer over mutual funds, which are priced and transacted only once daily.

How market makers support liquidity

In the secondary market, market makers provide liquidity by posting bid and ask prices. The bid is the price at which a market maker is willing to buy shares; the ask is the price at which they're willing to sell. The difference between the two is the spread, which represents a cost of trading.

Tighter spreads generally indicate higher liquidity and lower transaction costs. Market makers continuously adjust their quotes based on the value of the ETF's underlying holdings, the volume of trading activity, and broader market conditions. Their presence ensures that investors can trade even when there isn't an immediate natural match between buyers and sellers.

The primary market

Where shares are created and redeemed

Behind the scenes, the primary market is where authorized participants (APs) interact directly with the ETF provider to create or redeem shares. This process is what allows the supply of ETF shares to adjust dynamically, keeping the fund's market price closely aligned with the value of its underlying assets.

Creation: Adding new shares

When demand for an ETF increases – perhaps due to strong investor interest – APs can create new shares by delivering a basket of the fund's underlying securities (or, in some cases, cash) to the ETF provider. In exchange, the AP receives newly issued ETF shares, typically in large blocks called creation units.

Once the AP receives the newly created shares, it can sell them on the secondary market to meet investor demand. This increases the number of ETF shares outstanding, helping to satisfy buying pressure and prevent the ETF's price from rising too far above the value of its holdings.

Redemption: Removing shares

Conversely, when demand for an ETF falls, APs can redeem shares by purchasing ETF shares on the secondary market and returning them to the fund provider in redemption‑unit blocks. In exchange, the AP receives the underlying securities (or cash) that those shares represent.

This redemption process reduces the number of shares outstanding, helping to absorb selling pressure and prevent the ETF's price from falling too far below the value of its holdings.

In‑kind vs. Cash transactions

In most cases, creation and redemption involve in‑kind transactions, meaning securities are exchanged rather than cash. This mechanism has important tax implications: by transferring securities rather than selling them, the fund may avoid realizing capital gains, which benefits existing shareholders.

However, some ETFs – particularly those holding less liquid assets, such as bonds or international equities – may use cash transactions or a combination of cash and securities. Active ETFs may also use negotiated baskets, where the AP and fund provider agree on a customized set of securities for creation or redemption, helping to protect proprietary strategies or manage liquidity challenges.

How the two markets work together

The genius of the ETF structure lies in how the primary and secondary markets interact:

This arbitrage mechanism keeps the ETF's market price closely aligned with its net asset value (NAV), even during periods of heavy trading or market volatility.

Creation units and liquidity

A common misconception is that an ETF's liquidity depends solely on how many shares trade daily. In reality, ETF liquidity is primarily driven by the liquidity of the underlying securities the fund holds.

An ETF holding highly liquid stocks – such as large cap US equities – can absorb large trades even if its own trading volume is modest, because APs can efficiently create or redeem shares as needed. Conversely, an ETF holding thinly traded securities – such as small cap stocks or emerging market bonds – may face wider spreads and higher trading costs, reflecting the difficulty of transacting in the underlying assets.

For investors and advisors, this means evaluating ETF liquidity requires looking beyond the fund's own trading volume to assess the liquidity of what it holds.

Why the dual‑market structure matters

The primary and secondary market mechanism is what makes ETFs unique. It allows:

This structure is why ETFs have become a preferred vehicle for both retail and institutional investors seeking, liquid, and cost‑effective exposure to markets and strategies.