ETF shares are created through a wholesale process: a large broker-dealer known as an authorized participant delivers a basket of securities to the fund sponsor and receives, in return, a newly issued block of ETF shares called a creation unit. Those units usually run from 25,000 to 250,000 shares. The authorized participant then breaks the block apart and sells the individual shares on a stock exchange, where anyone with a brokerage account can buy them. A mirror-image redemption process runs in the other direction, and together the two keep an ETF’s market price tethered to the value of what it holds.
Who Can Create ETF Shares
Only authorized participants can create new shares directly with the fund. Under SEC Rule 6c-11, an authorized participant is a member of a registered clearing agency 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.1eCFR. 17 CFR 270.6c-11 – Exchange-Traded Funds In practice these are large broker-dealers and market-making firms with the balance sheets to move tens of millions of dollars of securities in a single transaction.
Because they are broker-dealers, authorized participants also fall under the SEC’s Net Capital Rule, which requires them to keep minimum capital reserves against their liabilities.2eCFR. 17 CFR 240.15c3-1 – Net Capital Requirements for Brokers or Dealers That cushion protects the creation and redemption process from a participant failing to deliver on its side of a trade. The bar is high by design, which is why only a handful of firms serve as authorized participants for any given fund.
Individual investors cannot create shares. Neither can most institutions. If you want ETF exposure, you buy existing shares on the exchange.
The Daily Portfolio Composition File
Before an authorized participant can assemble a basket, it has to know precisely what the fund wants. Each business day, the fund sponsor publishes a portfolio composition file listing every security, its quantity, and the cash component needed to build one creation unit. The Depository Trust and Clearing Corporation consolidates these files from more than 90 ETF issuers covering over 3,000 U.S.-listed funds, with each file available by 10:00 p.m. Eastern the night before the trading day it applies to.3DTCC. Exchange Traded Funds Portfolio Data Overview
The file is exact. Equity ETFs specify the precise share count of each stock. Bond ETFs list specific securities by identifier. The authorized participant has to acquire every component before it can submit a creation order, which can mean buying hundreds of individual securities on the open market and assembling them in the exact proportions the fund demands. The fund’s custodian will reject a basket that doesn’t match.
In-Kind Creation, Step by Step
The standard method is an in-kind exchange. The authorized participant delivers the basket of securities to the fund’s custodian bank, and the fund sponsor issues a creation unit in return. No cash changes hands for the securities themselves, though a small balancing amount may cover rounding differences between the basket’s value and the creation unit’s net asset value.1eCFR. 17 CFR 270.6c-11 – Exchange-Traded Funds The custodian verifies every component before the newly minted shares are electronically credited to the participant through the DTCC’s settlement system.4DTCC. Client Business Requirements – T0 Same Day Settling Create/Redeem Cycle
In-kind exchange sits at the center of the ETF structure. Securities go in, shares come out, and because the transaction is an exchange rather than a sale, no taxable event is triggered at the fund level when creation happens. The SEC has described in-kind creation and redemption as providing “flexibility and cost savings to ETP issuers, authorized participants, and investors, resulting in a more efficient market.”5U.S. Securities and Exchange Commission. SEC Permits In-Kind Creations and Redemptions for Crypto ETPs>
When Creation Happens in Cash Instead
Not every ETF can use in-kind creation. When the underlying assets are hard for a broker-dealer to acquire directly, such as international securities trading in different time zones, certain fixed-income instruments, or commodities like Bitcoin, the fund sponsor may require cash creation. In that case the authorized participant delivers the full dollar value of a creation unit, and the fund sponsor handles buying the underlying assets itself. The SEC originally required spot Bitcoin and Ether ETPs to use cash-only creation and redemption, then approved in-kind transactions for those products in 2025.6U.S. Securities and Exchange Commission. SEC Permits In-Kind Creations and Redemptions for Crypto ETPs Cash creation is less tax-efficient, because the fund itself has to buy and sell securities, which can generate capital gains that pass through to shareholders.
How New Shares Reach Ordinary Investors
Once the authorized participant holds a creation unit, it breaks the block into individual shares and sells them on a national securities exchange such as the NYSE or Cboe BZX. From that point the shares trade like any other stock. You can buy one share through a standard brokerage account without knowing or caring that the block it came from was assembled overnight by a broker-dealer delivering baskets of stocks to a custodian.
There is one distinction worth keeping straight. Authorized participants handle creation and redemption in the primary market. Market makers quote continuous buy and sell prices on the exchange throughout the day. Sometimes a single firm plays both roles, but often they are separate entities. A market maker that is not itself an authorized participant can outsource the creation and redemption function to one that is, so the supply mechanism keeps working even when different parties handle different parts of the chain.
Redemption Works the Same Way in Reverse
Redemption is creation run backward. An authorized participant gathers a redemption unit’s worth of ETF shares, typically the same size as a creation unit, and delivers them to the fund sponsor. In exchange, the sponsor hands back the underlying securities in their appropriate weightings. The returned ETF shares are cancelled, reducing the total supply.
Like creation, redemption is normally in-kind. The authorized participant receives actual stocks or bonds rather than cash, which again keeps taxable events from being triggered at the fund level. The daily portfolio composition file generally specifies the same basket for both creation and redemption, so the securities you’d deliver to create a unit match what you’d receive if you redeemed one.3DTCC. Exchange Traded Funds Portfolio Data Overview Individual investors cannot redeem shares directly with the fund sponsor. You sell your shares on the exchange like any other stock, and the redemption mechanism operates behind the scenes when authorized participants choose to use it.
Why the Whole System Exists: Arbitrage
The creation and redemption process isn’t just plumbing. It’s the mechanism that keeps ETF share prices in line with the value of the securities the fund actually holds, and the whole system runs on authorized participants chasing small profits.
When heavy buying pushes an ETF’s market price above the value of its underlying holdings, an authorized participant can buy the cheaper underlying securities, deliver them to the fund sponsor as a creation basket, receive new ETF shares, and sell those shares at the higher market price. The profit is the gap. The new supply of shares entering the market pushes the ETF’s price back down toward fair value.
When an ETF trades below the value of its holdings, the trade reverses. The authorized participant buys the cheaper ETF shares on the exchange, redeems them with the fund sponsor for the underlying securities, and sells those securities at their higher market value. This removes ETF shares from circulation, reducing supply and pushing the price back up.
The constant back-and-forth keeps most large, liquid ETFs trading within pennies of their net asset value. Two data sources make it possible. ETFs relying on Rule 6c-11 must post complete portfolio holdings on their website every business day before the exchange opens, including ticker symbols, identifiers, quantities, and percentage weights for every holding.7U.S. Securities and Exchange Commission. ADI 2025-15 – Website Posting Requirements The listing exchange also calculates and publishes an intraday indicative value every 15 seconds throughout the trading day, giving authorized participants a running estimate of what one share is actually worth based on current prices of the underlying securities. When the indicative value diverges from the market price, an arbitrage opportunity opens and participants move quickly to close it.
A separate reporting system, Form N-PORT, requires funds to file detailed portfolio data with the SEC monthly, though the information is made public only quarterly with a 60-day delay.8Federal Register. Form N-PORT Reporting N-PORT is for regulatory oversight, not real-time trading. The daily website disclosures and the intraday indicative value are what actually feed the arbitrage mechanism.
Why In-Kind Creation Matters for Taxes
The in-kind creation and redemption process gives ETFs a structural tax advantage over mutual funds. When you sell shares of a mutual fund, the fund itself often has to sell underlying securities to raise cash for your redemption. If those securities have appreciated, the fund realizes a capital gain that gets distributed to every remaining shareholder, including those who didn’t sell anything. You can owe tax because of someone else’s decision to leave.
ETFs largely sidestep this. When you sell ETF shares, you sell to another investor on the exchange. The fund doesn’t need to sell anything. And when an authorized participant redeems creation units, the fund delivers securities in-kind rather than selling them for cash, so no capital gain is realized at the fund level. In 2025, only about 7% of ETFs distributed a capital gain to shareholders, compared with roughly 52% of mutual funds. The gap is a direct consequence of how ETF shares are created and redeemed in the first place.