How Market Makers Profit on ETFs

NEW YORK (TheStreet) -- High-frequency trading is a looming presence in the exchange-traded fund industry, in which firms like Goldman Sachs (GS) can lock in profits almost instantaneously through arbitrage. Both bona fide market makers and proprietary traders are seeking out the fastest way to hedge trades, create units and maximize ETF trading capabilities.

High-speed trading in ETFs comes down to speed and volume. How does this work in the market-maker business? Lead market makers on the New York Stock Exchange's electronic trading platform Arca are given a bona fide hedging exemption to allow for a more "fair" and "orderly" market. Lead market makers must stand ready to both buy and sell their assigned products on a continuous basis. Lead market makers also serve as a sort of "investor" for the ETF industry.

When an ETF is premiered, its assigned lead market maker will create the first units, delivering the contents of a product's basket in exchange for shares of the ETF. After that, the lead market maker will generally sell shares of the ETF to buyers and hedge the sales by buying the equivalent number of underlying shares.

Previously, I have used the example of a fictional ETF called "U.S. Cell Phone Fund," or UCF, to illustrate the trading process . For purposes of illustration, let's assume that UCF is made up of just AT&T(T), Verizon(VZ) and Sprint(S). Let's say that a 50,000-share unit of UCF contains 50% AT&T, 30% Verizon and 20% Sprint. In this example, we'll assume that a high-frequency trading firm such as Goldman Sachs is assigned to be the lead market maker during the listing process.