In the world of exchange-traded funds (ETFs), authorized participants (APs) play an integral role. They work behind the scenes to ensure that funds are priced at fair value.
If you’re new to ETF investing, there’s a good chance you haven’t learned about authorized participants. APs are a major cog in the market, and are primarily responsible for the ETF creation/redemption mechanism, which essentially refers to how funds gain exposure to the market. The creation/redemption mechanism ensures that ETFs are affordable, more transparent and more tax-efficient than mutual funds.
These responsibilities mean that APs play an important role in liquidity. That’s because they are essentially liquidity providers that have the power to adjust the supply of ETF shares available. For example, if they identify a shortage in the market, they simply create more shares. On the flipside, they will reduce the number of shares should there be an excess supply of funds available. They do this through the creation/redemption mechanism.
As one might expect, APs have considerable influence on the ETF market. Just how much influence they wield depends solely on the issuer of the fund. Prior to launching an ETF, an issuer will assign one or more APs to their fund. This number can increase or decrease over time, although the leading ETFs have dozens of authorized representatives at the helm. It is generally believed that the more APs available, the better.
In terms of who they are, APs are typically large institutions, such as market makers or other industry specialists. The market has become fairly concentrated, with large banks controlling the lion’s share of the AP market. This means banks like Merrill Lynch, Morgan Stanley, Goldman Sachs and Fortis Bank.
That being said, an authorized participant is not the same as a money maker. Although both are essential to liquidity, APs are the ones who can actually trade the underlying basket versus the ETF itself. This means APs have vast permission structures, having gone through all the necessary paperwork with the major fund issuers.
Since APs create and redeem fund shares, they have a direct impact on underlying liquidity. After all, their main purpose is to ensure that their fund is valued fairly. To accomplish this, they identify shortage and excess in the market and execute a plan of action accordingly.
At the same time, APs closely monitor rising demand for their fund. As demand rises, a larger premium typically ensues. To ensure that the premium doesn’t get out of control, APs will create more shares, thereby controlling the value of the ETF. If an exodus from the fund occurs and a discount ensues, APs will buy shares on the open market before redeeming them with the issuer.
Naturally, the function of the AP varies vastly based on ETF. Liquid ETFs that track the major U.S. equity indices are much easier to manage from the perspective of an authorized participant. However, funds that track emerging market stocks or obscure markets are more difficult to hedge.
The Bottom Line
A crash course on authorized participants is usually helpful for new investors and those who have been around a while but have not been exposed to what goes on behind the scenes. This information will help you understand the inner workings of the ETF market, which can help you converge on future portfolio-building strategies.