Stage 4: Exchange
Shares of ETFs and ETVs trade intraday, thus requiring the product to be listed with a primary exchange, such as the Amex, NYSE or Nasdaq. It is important to choose a primary exchange that best suits your needs. Key considerations include product support, reputation, liquidity, trading volume and cross-listing arrangements. It is important to note that nonprimary exchanges can apply for unlisted trading privileges (UTP) on a particular product.
Stage 5: Service Providers
The role of service providers has grown in importance in recent years; for example, portfolio valuation and NAV accuracy have undergone increased scrutiny to ensure investor protection. Settlement, back-office and clearing procedures also are looked at closely by regulators. As product innovation expands to include commodity, currency, fixed-income and other derivative-linked products, so does the need to establish modified operational workflows. For example, commodities are not securities, and therefore do not clear and settle through DTC. Furthermore, in addition to the SEC, commodities trades may be governed by the Commodities Futures Trading Exchange (CFTC). These differences require modified settlement and pricing procedures when compared to domestic equities and ETFs, and raise other regulatory and/or tax issues. When dealing with international securities, local market settlement procedures apply, and because some jurisdictions have settlement cycles longer than seven calendar days, ETFs holding foreign securities may need relief to delay the payment of redemption securities.
When seeking a service provider, important considerations include the firm's reputation and commitment, technology and complete product offering. Some ETFs, like funds, are eligible to participate in securities lending, generating income that is an effective means to lower total expense ratios. This is another thing to consider.
Backstage 5: Required Services
ETFs and ETVs require some, but not all, of the same services, and the requirements vary among the different ETF structures as well. Most ETFs, as open-end companies, require a registered investment advisor, a chief compliance officer and the other providers commonly used by a mutual fund, including a custodian, administrator, fund accountant, transfer agent and distributor. ETFs organized as unit investment trusts, as well as ETVs organized as grantor trusts, must have a trustee, whose duties and services extend to more than safekeeping assets and record keeping. All ETFs, as ICs, must adopt a variety of required policies and procedures, including a code of ethics and a chief compliance officer procedures and compliance handbook.
Stage 6: Distributor
If you are not going to act as your own distributor, it is important to work closely with one. The role of the distributor is to take the orders from the APs and, often, to act as the liaison between the ETF's transfer agent and the APs. The distributor passes the order information to the transfer agent, who either creates or redeems the shares in creation units.
Stage 7: Specialist
A specialist is a member of a stock exchange who maintains a fair and orderly market in one or more securities. A market-maker performs a similar but not identical function in a securities market. A specialist performs two main functions: executing limit orders on behalf of other exchange members (for which the specialist typically charges a commission), and providing liquidity by buying or selling (sometimes short) for the specialist's own account in the absence of limit orders at a price point. This helps to counteract temporary imbalances in supply and demand, preventing wide swings in price spreads.
Stage 8: Authorized Participants (APs)
As we have seen, ETFs and ETVs operate both in a primary and a secondary market environment. Apart from the fact that the portfolio assets of an ETF or ETV can appreciate or depreciate due to market events, creation/redemption orders for shares entered by APs have a direct impact on the assets underlying an ETF or ETV. APs are the large institutional counterparties who enter into an agreement with the ETF or ETV, which permits them to participate in the creation/redemption process. The APs' ability to continuously expand or contract the supply of shares permits them and others to profit from any slight premium or discount in the market price of individual shares on the exchange versus the NAV of the underlying assets (arbitrage opportunities).
Arbitrage opportunities occur because the intraday market price for shares usually is close, but not equal, to the daily NAV of its ETF or ETV. Over time, if demand for shares exceeds current supply, the market price for a share of an ETF or ETV may actually be higher than its underlying NAV; conversely, if there are more sellers than buyers for a particular ETV or ETF, the market price for shares in the secondary market may be lower than the NAV for such shares. The APs' ability to take advantage of the arbitrage opportunities by creating and redeeming shares contributes to the liquidity available in the secondary market and, in turn, helps keep a relatively small gap between the trading prices for shares as compared to their NAV. Since ETFs and ETVs receive relief to exempt trading in their shares from the short sell "uptick" rule, it is important to enter into agreements with APs that have a long interest in the ETF or ETV, because their ability to create/redeem shares provides liquidity, asset growth and a possible inventory of shares to lend short. Unless stated in its prospectus, there is no limit to the number of APs an ETF or an ETV can have.
Stage 9: Registration Process
Now you are ready to file a registration statement for the ETF or ETV. If you haven't already done so, you will need to retain an attorney to help you prepare and file the registration statement (including the prospectus and exhibits) with the SEC for review and comment. He or she also will negotiate with the SEC and file amendments to the statement, and will finalize the prospectus and other materials.
If you are establishing an ETF, you will also need to create an IC, such as a trust or fund company, and register the IC with the SEC under the 1940 Act. Depending upon the structure you have chosen, such as an ETV structured as a grantor trust or an ETF structured as a unit investment trust, the attorney will draft the trust document as well as other material contracts. If you are setting up an open-end company, the attorney will create and/or review policies and pro c e d u res for the IC, such as investment policies. These and other policies are re q u i red to be adopted and/or reviewed by the board of an open-end company on a periodic basis. Your attorney will attend organizational and any additional board meetings prior to the effectiveness of the open-end fund's registration statement. In most cases, the attorney will also coordinate with auditors and other service providers, draft material contracts and review advertising materials.
Stage 10: Give It A Go?
Still interested in bringing an ETF to market? Although launching an ETF or ETV fund can be a process with a lot of moving parts, it is also a thrilling time. By now, you've worked countless months putting in those long hours, often waking up at your desk and realizing it was 2:00 a.m. You're days away from gaining SEC approval. Five authorized participants have signed up, and you have set the launch date. As you ring the opening bell on the stock exchange on the first day of trading, you let out a sigh of relief, congratulate yourself and your partners, and then realize you now have a new battle: sales and marketing.