Creation Unit

The Definition in SEC Rule 6c-11

Under Rule 6c-11(a)(1), creation unit means a specified number of exchange-traded fund shares that the exchange-traded fund will issue to, or redeem from, an authorized participant in exchange for the deposit, or delivery, of a basket and a cash balancing amount if any.

The creation unit is also part of the definition of the fund itself. Under Rule 6c-11(a)(1), exchange-traded fund means a registered open-end management company that issues, and redeems, creation units to, and from, authorized participants in exchange for a basket and a cash balancing amount if any, and whose shares are listed on a national securities exchange and traded at market-determined prices.

Under Rule 6c-11(a)(1), exchange-traded fund share means a share of stock issued by an exchange-traded fund. Under the same paragraph, national securities exchange means an exchange that is registered with the Commission under section 6 of the Securities Exchange Act of 1934.

Terms Used in the Definition

Under Rule 6c-11(a)(1), authorized participant means a member or participant of a clearing agency registered with the Commission, which has a written agreement with the exchange-traded fund or one of its service providers that allows the authorized participant to place orders for the purchase and redemption of creation units.

Under Rule 6c-11(a)(1), basket means the securities, assets or other positions in exchange for which an exchange-traded fund issues, or in return for which it redeems, creation units.

Under Rule 6c-11(a)(1), cash balancing amount means an amount of cash to account for any difference between the value of the basket and the net asset value of a creation unit.

Under Rule 6c-11(a)(1), portfolio holdings means the securities, assets or other positions held by the exchange-traded fund.

Under Rule 6c-11(a)(1), business day means any day the exchange-traded fund is open for business, including any day when it satisfies redemption requests as required by section 22(e) of the Investment Company Act of 1940 (the Act).

Under Rule 6c-11(a)(1), custom basket means a basket that is composed of a non-representative selection of the exchange-traded fund’s portfolio holdings, or a representative basket that is different from the initial basket used in transactions on the same business day.

The Primary Market and the Secondary Market

An ETF enters into contracts with financial institutions, typically large broker-dealers, to act as authorized participants. Authorized participants purchase and redeem shares directly with the ETF in the primary market in large blocks of shares called creation units. Authorized participants typically sell some or all of their ETF shares in the secondary market, on an exchange. This enables investors to buy and sell ETF shares like the shares of any publicly traded company.

ETF shares are traded throughout the day on national stock exchanges and at market prices. Typically only authorized participants purchase and redeem shares directly from the ETF. In addition, they can do so only in large aggregations or blocks. Other investors, including retail investors, purchase and sell ETF shares in market transactions at market prices.

How a Creation Unit Is Created

To purchase shares from an ETF, an authorized participant assembles and deposits a designated basket of securities and cash with the ETF in exchange for which it receives ETF shares.

Once the authorized participant receives the ETF shares, the authorized participant is free to sell the ETF shares on a national stock exchange to retail investors, institutions, or market makers in the ETF.

Authorized participants typically pay for creation units in an in-kind exchange with a group or basket of securities and other assets that generally mirrors the ETF’s portfolio.

How a Creation Unit Is Redeemed

The redemption process is the reverse of the creation process. An authorized participant buys a large block of ETF shares on the open market and delivers those shares to the fund. In return, the authorized participant receives a pre-defined basket of individual securities, or the cash equivalent.

Rule 6c-11(b)(4) addresses a redemption that includes a foreign investment. Under Rule 6c-11(a)(1), foreign investment means any security, asset or other position of the ETF issued by a foreign issuer as that term is defined in section 240.3b-4 of Title 17 of the Code of Federal Regulations (CFR), and that is traded on a trading market outside of the United States. If an exchange-traded fund includes a foreign investment in its basket, and if a local market holiday, or series of consecutive holidays, or the extended delivery cycles for transferring foreign investments to redeeming authorized participants prevents timely delivery of the foreign investment in response to a redemption request, the exchange-traded fund is exempt, with respect to the delivery of the foreign investment, from the prohibition in section 22(e) of the Act against postponing the date of satisfaction upon redemption for more than seven days after the tender of a redeemable security, if the exchange-traded fund delivers the foreign investment as soon as practicable, but in no event later than fifteen days after the tender of the exchange-traded fund shares.

In-Kind Exchanges and Tax Efficiency

ETFs can be tax efficient because many ETFs buy and sell portfolio securities in in-kind exchanges, rather than for cash. This means ETFs typically have fewer capital gain distributions than mutual funds. As a result, ETF shareholders may pay less in taxes on a similar investment.

ETF shares generally are redeemable in kind. An ETF may deliver specified portfolio securities to authorized participants who are redeeming creation units instead of selling portfolio securities to meet redemption demands, which could otherwise result in taxable gains to the ETF. Typically, such taxable gains, if not otherwise offset by the ETF, would be passed through to the retail investor.

Creation Unit Size

Authorized participants purchase and redeem ETF shares directly from the ETF in large aggregations or blocks, and a block of 50,000 ETF shares is one such size. The definition in Rule 6c-11(a)(1) refers to a specified number of exchange-traded fund shares.

Rule 6c-11(a)(2) sets out a circumstance in which individual shares are sold or redeemed. Under that paragraph, notwithstanding the definition of exchange-traded fund in paragraph (a)(1), an exchange-traded fund is not prohibited from selling, or redeeming, individual shares on the day of consummation of a reorganization, merger, conversion or liquidation, and is not limited to transactions with authorized participants under these circumstances.

Arbitrage and the Market Price

An ETF’s market price typically will be more or less than the fund’s NAV per share, which is called selling at a premium or discount. The market price fluctuates during the trading day as a result of a variety of factors, including the underlying prices of the ETF’s assets and the demand for the ETF. The NAV is the value of the ETF’s assets minus its liabilities, as calculated by the ETF at the end of each business day.

Under Rule 6c-11(a)(1), premium or discount means the positive or negative difference between the market price of an exchange-traded fund share at the time as of which the current net asset value is calculated and the exchange-traded fund’s current net asset value per share, expressed as a percentage of the exchange-traded fund share’s current net asset value per share.

Arbitrage is the practice of taking advantage of a price differential between two or more markets. An arbitrage opportunity is inherent in the ETF structure because the ETF’s market price fluctuates during the trading day. Due to this fluctuation, the ETF’s market price may not equal the ETF’s end-of-day NAV per share. Authorized participants can arbitrage this difference, and make a profit, because they can trade directly with the ETF at NAV as well as on the market.

The expected result of the arbitrage activity is that the market price of the ETF’s shares moves back in line with the ETF’s NAV per share, and retail investors are able to buy ETF shares on an exchange at a price that is close to the ETF’s NAV per share. An ETF’s market price is generally kept close to the ETF’s end-of-day NAV per share because of the arbitrage function inherent to the structure of the ETF.

Unlike with a mutual fund, retail investors may transact at prices that can deviate, sometimes significantly, from the underlying value of the exchange-traded product (ETP). Disruption in the share redemption or creation process is one situation in which an ETP’s price can diverge significantly from the underlying value of its portfolio.

Investors can compare an ETP’s market price with published estimates of its value, such as an intraday indicative value, and can consider order types other than market orders. Public sources, as well as an investment professional, generally can provide timely information on the extent to which an ETP’s current market price might be at a premium or discount to its estimated value.

Bid-Ask Spreads

ETFs that are more liquid and have higher trading volume typically have tighter or smaller spreads. The spread can be thought of as a hidden cost to investors since spreads reduce potential returns. Sometimes, an ETP may have wide bid-ask spreads or may trade at a large premium or discount to its value, depending on a product’s trading volume and other market factors.

Information about an ETF’s median bid-ask spread is available on the ETF’s website. Under Rule 6c-11(c)(1)(v), an ETF must disclose its median bid-ask spread, expressed as a percentage rounded to the nearest hundredth, computed by identifying the ETF’s national best bid and national best offer as of the end of each ten second interval during each trading day of the last thirty calendar days, dividing the difference between each such bid and offer by the midpoint of the national best bid and national best offer, and identifying the median of those values.

Baskets and Custom Baskets

Under Rule 6c-11(c)(3), an exchange-traded fund must adopt and implement written policies and procedures that govern the construction of baskets and the process that will be used for the acceptance of baskets. If the exchange-traded fund uses a custom basket, these written policies and procedures also must set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the exchange-traded fund and its shareholders, including the process for any revisions to, or deviations from, those parameters, and must specify the titles or roles of the employees of the exchange-traded fund’s investment adviser who are required to review each custom basket for compliance with those parameters.

Under Rule 6c-11(c)(2), the portfolio holdings that form the basis for the exchange-traded fund’s next calculation of current net asset value per share must be the ETF’s portfolio holdings as of the close of business on the prior business day.

Daily Website Disclosure

Under Rule 6c-11(c)(1), each business day, an exchange-traded fund must disclose prominently on its website, which is publicly available and free of charge, six categories of information. Most ETFs post their portfolio holdings on their websites daily.

Under Rule 6c-11(c)(1)(i), the first category is, before the opening of regular trading on the primary listing exchange of the exchange-traded fund shares, the following information, as applicable, for each portfolio holding that will form the basis of the next calculation of current net asset value per share: ticker symbol; CUSIP or other identifier; description of holding; quantity of each security or other asset held; and percentage weight of the holding in the portfolio.

Under Rule 6c-11(c)(1)(ii), the second category is the exchange-traded fund’s current net asset value per share, market price, and premium or discount, each as of the end of the prior business day.

Under Rule 6c-11(c)(1)(iii), the third category is a table showing the number of days the exchange-traded fund’s shares traded at a premium or discount during the most recently completed calendar year and the most recently completed calendar quarters since that year, or the life of the exchange-traded fund, if shorter.

Under Rule 6c-11(c)(1)(iv), the fourth category is a line graph showing exchange-traded fund share premiums or discounts for the most recently completed calendar year and the most recently completed calendar quarters since that year, or the life of the exchange-traded fund, if shorter.

Under Rule 6c-11(c)(1)(v), the fifth category is the exchange-traded fund’s median bid-ask spread, computed as described above.

Under Rule 6c-11(c)(1)(vi), the sixth category applies if the exchange-traded fund’s premium or discount is greater than 2 percent for more than seven consecutive trading days. It is a statement that the exchange-traded fund’s premium or discount, as applicable, was greater than 2 percent and a discussion of the factors that are reasonably believed to have materially contributed to the premium or discount, which must be maintained on the website for at least one year thereafter.

Exemptions and Conditions in Rule 6c-11

Under Rule 6c-11(b), if the conditions of paragraph (c) are satisfied, an exchange-traded fund share is considered a redeemable security within the meaning of section 2(a)(32) of the Act, and a dealer in exchange-traded fund shares is exempt from section 22(d) of the Act and 17 CFR 270.22c-1(a) with regard to purchases, sales and repurchases of exchange-traded fund shares at market-determined prices.

Under Rule 6c-11(b)(3), a person who is an affiliated person of an exchange-traded fund, or who is an affiliated person of such a person, solely by reason of holding with the power to vote 5 percent or more of the exchange-traded fund’s shares, or holding with the power to vote 5 percent or more of any investment company that is an affiliated person of the exchange-traded fund, is exempt from sections 17(a)(1) and 17(a)(2) of the Act with regard to the deposit and receipt of baskets.

Under Rule 6c-11(c)(4), an exchange-traded fund that seeks, directly or indirectly, to provide investment returns that correspond to the performance of a market index by a specified multiple, or to provide investment returns that have an inverse relationship to the performance of a market index, over a predetermined period of time, must comply with all applicable provisions of 17 CFR 270.18f-4.

Exchange-Traded Notes

While similar to the creation and redemption mechanism for other ETPs, exchange-traded notes (ETNs) don’t use authorized participants. Instead, an ETN issuer has primary control over ETN issuance and redemption, as this directly impacts the issuer’s balance sheet.

Exam Relevance

Candidates should check the current outline for their examination.

The Securities Industry Essentials (SIE) Exam content outline lists, in Section 2, Understanding Products and Their Risks, Topic 2.1.9, Exchange-traded Products (ETPs). Types of ETPs lists exchange-traded funds (ETFs) and exchange-traded notes (ETNs) beneath it. The knowledge bullets for that topic list alternative investments to mutual funds, fee considerations, and active vs. passive.

The Series 7 content outline lists, in Function 3, Section 3.2, Reviews and analyzes customers’ investment profiles and product options to determine that investment recommendations meet applicable standards, under Packaged products, the bullet Investment companies, exchange-traded funds (ETFs), unit investment trusts (UITs).

Common Misunderstandings

Retail investors buy creation units. An ETF does not sell individual shares directly to, or redeem individual shares directly from, retail investors, and typically only authorized participants purchase and redeem shares directly from the ETF.

A creation unit is a single ETF share. A creation unit is a specified number of exchange-traded fund shares, and creation units are large blocks of shares, typically 50,000 shares or more.

Creation units are always paid for in cash. Authorized participants typically pay for creation units in an in-kind exchange with a group or basket of securities and other assets that generally mirrors the ETF’s portfolio, and a cash balancing amount accounts for any difference between the value of the basket and the net asset value of a creation unit.

Anyone can be an authorized participant. Under Rule 6c-11(a)(1), an authorized participant is a member or participant of a clearing agency registered with the Commission that has a written agreement with the exchange-traded fund or one of its service providers.

An ETF share always trades at NAV. An ETF’s market price typically will be more or less than the fund’s NAV per share. Arbitrage by authorized participants keeps the market price generally close to the end-of-day NAV per share.

Every exchange-traded product uses authorized participants. ETNs don’t use authorized participants. An ETN issuer has primary control over ETN issuance and redemption.

Key Points to Retain

A creation unit is a specified number of ETF shares that the ETF issues to, or redeems from, an authorized participant in exchange for the deposit, or delivery, of a basket and a cash balancing amount, if any.

Creation units are large blocks of shares, typically 50,000 shares or more, usually sold in in-kind exchanges to authorized participants.

An authorized participant is a member or participant of a clearing agency registered with the Commission that has a written agreement with the ETF or one of its service providers allowing it to place orders for the purchase and redemption of creation units. Authorized participants typically are large broker-dealers.

To create, the authorized participant deposits a designated basket of securities and cash with the ETF and receives ETF shares. To redeem, the authorized participant delivers ETF shares to the fund and receives a pre-defined basket of individual securities, or the cash equivalent.

Retail investors buy and sell ETF shares in market transactions. They do not buy creation units from the ETF.

Authorized participants can trade directly with the ETF at NAV as well as on the market, and that arbitrage generally keeps the market price close to NAV.

Under Rule 6c-11(c)(3), an ETF must adopt and implement written policies and procedures that govern the construction of baskets and the acceptance of baskets, with added requirements for custom baskets.

Under Rule 6c-11(c)(1), each business day an ETF must disclose prominently on its website, which is publicly available and free of charge, its portfolio holdings, NAV per share, market price, premium or discount, and median bid-ask spread, among other items.

ETNs don’t use authorized participants, and an ETN issuer has primary control over ETN issuance and redemption.

The SIE Exam content outline lists exchange-traded funds (ETFs) and exchange-traded notes (ETNs) under Topic 2.1.9, and the Series 7 content outline lists exchange-traded funds (ETFs) under Packaged products.