The more market-making support an ETF has, the more liquid it tends to be, according to both the Ontario Securities Commission (OSC) and the Canadian Securities Administrators (CSA). Conversely, too few market makers are associated with higher spreads and lower liquidity.
Those findings were supported in two reports published in June. In one, the OSC examined the efficiency of the crucial arbitrage mechanism through which market makers maintain ETF liquidity by aligning the market price of an ETF with its net asset value (NAV).
The report informed the CSA’s consultation paper examining whether ETF issuers should be required to sign agreements with at least two market makers — for their own benefit and that of investors.
How market makers work
ETF issuers sign agreements with one or more authorized dealers, also known as authorized participants (APs), who are the only entities permitted to create or redeem ETF units on the primary market.
“The designated dealer is the one that provides the issuer with the initial capital — a minimum of $1 million — to launch the ETF and list it on an exchange,” Frédéric Viger, co-head of institutional ETF sales and himself a market maker at National Bank Capital Markets, explained. “That dealer becomes the lead market maker, ensuring that the ETF opens at the correct value and continues throughout the trading day to post buy and sell quotes that reflect its true price.”
APs may also sign agreements with the issuer, granting them the right to create or redeem ETF units.
“APs have a more flexible responsibility,” Viger said. “They can choose to participate only when it suits them. The lead market maker, on the other hand, has no choice but to be present.”
Other brokers can act as market makers at their discretion, by posting buy and sell quotes for ETF units throughout the trading day — helping to deepen liquidity and improve price discovery.
According to a July 2024 study by TD Securities, 51 brokers in Canada had posted a bid or ask on a TSX-listed ETF in Canada for a size of $100,000 or more over the previous three months. During the same period, the report noted that “only 19 market makers consistently entered a bid and ask on over 50% of the market hours in Canada on at least one ETF.”
In Canada, banks are the main market makers for ETFs, given the significant technological infrastructure and capital required, said TD Securities.
National Bank Financial is a major player in this space. It acts as the lead market maker for roughly 37% of all ETFs in Canada and holds a 38% share of trading volumes, Viger said. “In the rapidly expanding ETF market, it’s a position other banks compete for fiercely — and we’ve maintained roughly the same market share for five years.”
Liquidity and concentration risks
In Canada, a large portion of ETF trades occur between investors and market makers, which add value by maintaining fair pricing.
Having only one market maker poses a business risk for an ETF, TD said in its report.
“ETFs with a single market maker can see their bid-ask spreads widen dramatically — by up to tenfold — during unexpected outages,” it warned.
The OSC conducted a study of trading in ETFs covering the period from January 2019 to the end of 2023, focusing on secondary market liquidity and the efficacy of the ETF arbitrage mechanism. It showed that in December 2023, 71 ETFs — managed by five issuers and representing 8% of all ETFs — had only one AP. These were mostly small funds, accounting for less than 5% of total Canadian ETF assets.
“Nearly half of ETFs had at least eight APs, representing about 80% of the total net assets in the sample,” the OSC added.
ETFs with a larger number of APs show smaller deviations between market price and NAV, meaning they appear to improve arbitrage efficiency.
TD data show that ETFs with only one market maker, 266 in total, had an average deviation between price and NAV of 0.89% in 2024. For ETFs with two market makers (294 in all), the deviation fell to 0.73%. For ETFs with three (a total of 237), it dropped to 0.34%.
Between 2022 and 2024, the average number of active market makers per ETF rose from 2.5 to 3.8.
“It’s in issuers’ best interest to recruit more market makers to support their ETFs,” TD concluded.
Why so few market makers?
Several factors explain why some ETFs have limited market maker participation — including low trading volumes, which reduce arbitrage opportunities, and the lack of public disclosure of underlying holdings.
For commercial reasons, some issuers — particularly those managing actively managed ETFs — disclose their full portfolio holdings to only one authorized participant. That can be the case with actively managed ETFs.
Even so, the CSA observed that, “Most Canadian ETFs are liquid and function well, as shown by tight spreads and minimal deviation from NAV.”
However, during stress periods, such as when the Covid pandemic hit, spreads can widen dramatically.
“Displayed spreads and price deviations from NAV increased by nearly 10 times their normal levels” at the start of the pandemic, the OSC reported. Although they returned to pre-pandemic levels within a few months, the report noted that the median daily spread between price and NAV spiked to 119 basis points at the start of the pandemic compared to around nine basis points during normal conditions.
Regulatory questions
Having multiple APs able to trade ETF units reduces the risk that no one can create or redeem them when markets are volatile.
Engaging “a diverse group of APs with different risk appetites and constraints increases the likelihood that at least one will maintain arbitrage activity,” the CSA noted.
Adding more APs could also enhance competition.
“If an ETF manager already has a second AP capable of making markets, the first may be more motivated to keep bid-ask spreads tight and closely track the ETF’s underlying value,” the regulator wrote.
“This may be especially important for ETFs that do not publicly disclose portfolio information for arbitrage purposes.”
ETF issuers told the CSA that having multiple AP agreements reduces the risk of unfair informational advantages for APs who have access to non-public portfolio details.
The regulators are therefore asking whether they should mandate a minimum number of APs per ETF.
The data show a correlation between the number of APs and arbitrage efficiency — but causation is less clear. Ultimately, market supply and demand remain decisive.
“An ETF that doesn’t trade much won’t attract market makers — and more market makers won’t fix that,” Viger said. “It’s trading volume that draws in additional market makers, not the other way around. It’s competition from natural buyers and sellers that narrows spreads. … If we’re not the lead market maker on an ETF, we’re unlikely to jump in if there’s no volume.”
Barriers to entry
Requiring at least two market makers per ETF could raise barriers to entry for smaller issuers who often struggle to secure even one.
As Viger explained, smaller firms without established relationships sometimes turn to intermediaries — often referred to as white labellers — who handle administrative and financial details of the ETF launch, then approach a dealer to convince them that fronting the $1 million in seed capital is worthwhile. Only if the ETF gains traction and attracts buyers will additional market makers follow.
As for trading interruptions, Viger said these risks depend more on the quality and technological robustness of the lead market maker’s systems.
“If those systems aren’t efficient, other market makers can help. But if they are, adding more market makers won’t change much,” he said.
And when markets are extremely stressed or trading volume doesn’t justify it, no additional market maker will want to step in.
TD Securities’ report said that APs don’t all play the same role. Some become APs as part of their market-making function, while others do so mainly to facilitate ETF transactions. The latter may not engage in arbitrage or continuous price quoting.
More APs doesn’t necessarily mean more market makers — and it’s market makers that ETFs truly need, TD Securities emphasized.
Competition and compensation
In its proposal, which was open for comment until the end of October, the CSA also questioned whether exclusive agreements between an issuer and a lead AP should be prohibited. Such deals exist, Viger said, and are often motivated by confidentiality.
“Managers don’t want to disclose their strategies, trades or positions to the entire street. Exclusivity shouldn’t be banned — issuers should have that choice,” he said.
To reduce the risk of market-maker outages, regulators might require issuers to select lead market makers with strong, resilient systems — though enforcing that in practice would be challenging.
Finally, to encourage market makers to maintain a minimum level of market quality even when it’s not profitable to do so, TD Securities suggested a more direct incentive: “In Canada, no such arrangement exists today. Regulators should consider issuing guidance on compensation models for market making.”
This article was originally published in our sister publication Finance et Investissement. It was translated from French.