Hi Dubrov,
I'll try to address your points as well as I can:
Are you sure that the vast majority of ETFs do not invest phsically in the underlying. The last place I worked used to market make in a few ETFs and used the underlying to hedge it out. Granted, the underlyings were generally very liquid and not expensive to trade. If it is true, do you know the reason? I could only understand trading a swap to hedge the ETF if the underlying were difficult to trade or replicate(say due to illiquidity, national laws as in China, or contains non-exchange traded items).
I don't see why any serious market maker would give up most of their profit by going to an investment bank and getting them to price up a swap hedge.
Yes I am sure about this. I shouldnt have said that "the ETF market maker will use it (your money) to buy collateral". The thing is they already have it: Market makers have alot of securities on their books (govies, corporate bonds, stocks etc.). Take Barclays (iShares) for example. When an investor purchases an iShare, Barclays will, rather than going out and purchasing the components of the underlying index, put these securities to use. They do this by using them as collateral. So the iShare that was purchased now contains securities (that Barclays already have on their Balance Sheet and are not using) that does not match the required exposure. iShares then use their own swaps desk to swap out this exposure for that which is required by the iShare. This is actually cheaper for Barclays because they put securities that were tying up capital to use. The swaps desk will hedge out the performance it is required to pay using futures or whatever they can (it is actually more likely that an ETF will follow this structure if the underlying market is liquid and there are futures on it). An ETF on the ISEQ for example would just buy the individual shares.
Also, as dunkamania mentions, it is the fund manager who creates (or breaks) shares. However in most cases it is possible to give the basket of underlying shares to the fund manager and request them to be converted into ETF shares. The fund manager will charge a fee to the Market Maker for this facility.
I'm assuming the market maker and the fund manager are the same entity. Perhaps some market makers will provide this service but of course they'll charge a fee for it as they would have to sell the assets and set up the structure as above. If it's the ISEQ index their recieving they'd probably just take these on and not sell them but they'd probably still charge a fee. I'm not sure what your point is or if i'm properly addressing it?? Maybe clarify??
Lastly, the collateral posted against the swap has nothing to do with the investor buying the ETF. If the Market Maker defaults, the Investment bank is entitled to the collateral to cover any losses on the MTM of the Swap. The investor is unaffected as they stilll have their shares in the ETF. The fund manager may seek another company to act as market maker at that point.
When i said "if the market maker defaults you are left with the collateral" i was talking about the collateral in the fund (securities not being used by Barclays) and not the collateral that is posted against the swap. If the market maker defaults yes the IB on the other side of the Swap is entitled to the posted collateral (usually T-Bills or cash) but it is wrong to say the investor is unaffected. They would be left with the underlying collateral in the fund. If this included shares or corporates its value would almost certainly fall significantly on the back of such a default. Again fund manager/market maker... I just see these as the same.
Anyway I hope i've clarified the above somewhat.