ETF Education: What Are Authorized Participants?

January 10, 2018

[This article appears in our January 2018 issue of ETFR Report.]

Authorized participants (APs) are one of the major parties at the center of the ETF creation/redemption mechanism, and as such, they play a critical role in ETF liquidity. In essence, APs are ETF liquidity providers that have the exclusive right to change the supply of ETF shares on the market.

Role Of Authorized Participants 
When an ETF company wants to create new shares of its fund, whether to launch a new product or meet increasing market demand, it turns to an AP, which may be a market maker, a specialist or any other large financial institution. Essentially, it’s someone with a lot of buying power.

It is the AP’s job to acquire the securities that the ETF wants to hold. For instance, if an ETF is designed to track the S&P 500 Index, the AP will buy shares in all the S&P 500 constituents in the exact same weights as the index, then deliver those shares to the ETF provider. In exchange, the provider gives the AP a block of equally valued ETF shares, called a creation unit. These blocks are usually formed in blocks of 50,000 shares.

The exchange takes place on a one-for-one, fair-value basis. The AP delivers a certain amount of underlying securities and receives the exact same value in ETF shares, priced based on their net asset value (NAV), not the market value at which the ETF happens to be trading.

Both parties benefit from the transaction: The ETF provider gets the stocks it needs to track the index, and the AP gets plenty of ETF shares to resell for profit.

The process can also work in reverse. APs can remove ETF shares from the market by purchasing enough of those shares to form a creation unit and then delivering those shares to the ETF issuer. In exchange, APs receive the same value in the underlying securities of the fund.

How Do APs Gain The Right To Change The Supply Of ETP Shares? 
ETP issuers decide. Prior to launch, the issuer will designate one or more AP to the fund. More can sign up over time. The most popular ETFs will have dozens of APs.

How Do APs Impact Liquidity? 
An AP’s ability to create and redeem shares helps keep ETFs priced at fair value.

For example, if demand for an ETF increases and a premium develops, APs step in to create more shares and push the ETF’s price back in line with its actual value. If there’s a rush to sell and a discount develops, APs buy ETF shares on the open market and redeem them with the ETF issuers to reduce supply.

Generally, the greater the number of APs for a particular ETF, the better: The force of competition is more likely to keep the ETF trading close to its fair value.

The task set forth for an AP is not necessarily an easy one: Sometimes the underlying market that they must access to change the supply of ETF shares is illiquid, or just difficult to access. An exchange-traded product tracking the S&P 500 will be easy to access and easily hedge-able for most APs, while one tracking Nigeria equities will be tough.

Mostly, APs are invisible to individual investors and advisors. Still, it’s good to know they’re there.

Authorized Participants
… are designated by the ETF issuer
… have the exclusive right to change the supply of ETF shares on the market
… create shares when a premium develops by providing baskets of holdings to the issuers
… redeem shares when a discount develops by buying them from the issuer to sell the individual holdings on the market

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