Authorized Participants: Everything you Need to Know.
Exchange-traded funds (ETFs) have grown rapidly in both — size and scope — over the last decade. Global assets under management increased from $675 billion in 2008 to $8.4 trillion in the first quarter of 2021. Currently, more than 270 issuers offer over 7000 ETFs.
Many players support the mechanisms that allow ETFs to function efficiently. This article examines who authorized participants (APs) are — an institution that plays a central role in ensuring accurate ETF prices and smooth trading in all market conditions.
What is an authorized participant?
Authorized participants are entities that can issue and redeem shares of exchange-traded funds. They provide much of the liquidity of the ETF market, by raising the underlying assets needed to create ETF shares. If the market is short on ETF stocks, approved participants will make more. Conversely, if the price of the ETF is lower than the price of the underlying stock, the authorized participants will reduce the issued ETF stock. This can be achieved with a creation and redemption mechanism that matches the price of an ETF to its underlying Net Asset Value (NAV).
An authorized participant is responsible for acquiring the securities that the ETF will hold. For the S&P 500 index, all its components (weighted by market capitalization) are purchased and delivered to the sponsor. In return, APs will receive a package of shares of equal value, referred to as a creation unit. Issuers may engage in the services of one or more APs for a fund. Large and active funds tend to have a larger number of authorized participants. However, the number of participants also depends on the type of fund. On average, equities have more authorized participants than bonds, presumably because of the higher volume of transactions.
Traditionally, authorized participants have been major banks such as Merrill Lynch, Citigroup, Goldman Sachs, JP Morgan Chase, and Morgan Stanley. They do not receive compensation from any sponsors and have no legal obligation to redeem or create shares in ETFs. Instead, an authorized participant is rewarded through activities in the secondary market. It is important to note that small investors cannot become Aps.
In the end, both parties benefit from cooperation. The sponsor will be assisted in establishing the fund and the participants receive a block of shares for resale for profit. This process works in reverse. Authorized participants go on to receive the same value as the underlying securities in the fund, upon the sale of the shares. APs earn most of their profits in the ETF market through arbitrage.
Benefits of Authorized Participants
The main advantage of APs for investors is they bring the price of ETFs closer to the net asset value of the underlying security. Without them in the market, ETFs tend to be like closed-end funds. In such a situation, ETF prices can deviate significantly from their net asset value, with significant ups or downs. There are several such examples of closed-end funds that go significantly above or below the value of their assets. ETFs, on the other hand, remain close to their net asset value.
Authorized participants increase market transparency by bringing ETF prices closer to their net asset value. When investors buy ETFs, they essentially want to bet on a particular asset class. ETF buyers on the stock market naturally want their stock prices to go up. However, some long-term value investors prefer closed-end funds simply because they have the opportunity to find significant discounts. An authorized participant ensures that the premiums and rebates in the ETF market do not grow too high.
Multiple APs can help improve the liquidity of a particular ETF. Competition tends to bring funds closer to their fair value. More importantly, additional APs promote a more functional market. If one party ceases to act as an authorized participant, the others will consider the ETF a lucrative opportunity and offer to create or redeem the shares. At the same time, affected authorized participants have the choice to resolve internal issues and resume primary market activities.
Authorized participant vs Market maker
APs and market makers both play pivotal roles in ensuring that ETF trading is smooth, in all market conditions. A market maker is essentially a broker-dealer that provides two-sided (buy and sell) quotes to clients regularly. Market makers are key liquidity providers in the ETF ecosystem. They ensure continuous, smooth, and efficient ETF trading in the secondary market.
The role of the market maker is different from that of the AP, but both are necessary for smooth ETF trading. The market maker does not have to be an AP, nor does the AP need to be a market maker. Still, some companies play both roles in a particular ETF.
Examples of market makers include Susquehanna, Jane Street, and JP Morgan.
Frequently Asked Questions Expand All
Ans: Before the launch, the issuer allocates APs to the fund. There can be more sign-ups over time. It is commonly seen that the most popular ETFs have dozens of APs.
Ans: The role of the market maker is different from an AP, but both are necessary for smooth ETF trading. The market maker does not have to be an AP, nor does the AP need to be a market maker. Still, some companies play both roles in a particular ETF.
Ans: An authorized participant is an institution that has the right to create and redeem shares of an exchange-traded fund (ETF). They improve liquidity in the ETF market by obtaining the underlying assets required to create the shares of an ETF.