Authorized participants (APs) are the capital market’s facilitators of the ETF creation and redemption process. This process is a key feature that distinguishes ETFs from their mutual fund counterparts. Understanding the role APs play in the world of ETFs is critical for anyone who wants to launch any type of ETF.
An AP’s function in the ETF space is similar to that of a broker-dealer or other financial intermediary in the open-end space. In essence, the ETF distributor and the AP work together to facilitate the creation and redemption of ETF shares. The process works like this:
An ETF distributor and an AP will sign an agreement “authorizing” the AP to create and redeem shares with a specific ETF. ETF shares are available for creation and redemption in specific amounts that comprise what is called a creation unit. A typical creation unit is 50,000 ETF shares; at a $25 share price, this would equal $1.25 million worth of ETF shares.
To create shares of an ETF “in-kind,” an AP will bring $1.25 million worth of securities the ETF holds to the distributor. They’ll exchange those securities for $1.25 million worth of ETF shares. This is an example of creating ETF shares in its most simplistic form. When an AP needs to redeem shares, the process works in reverse. The AP will bring shares of the ETF and exchange those “in-kind” for shares of the securities the ETF holds.
It’s also possible for APs to purchase creation units with cash instead of exchanging actual securities for them. Fees for this type of transaction generally run higher, since the fund itself then has to execute trades for each individual security.
In order to act as middleman in this capacity, an AP must, in most cases, meet two qualifications:
• Be a licensed broker-dealer
• Be able to clear securities with the Depository Trust & Clearing Corporation (DTCC)
The DTCC serves as an additional layer of protection between the AP and the fund to guarantee the transaction. This oversight service ensures the AP delivers its securities to the ETF trust, and that the ETF delivers its shares to the AP.
In the ETF world, the role of a lead market maker (LMM) is to provide liquidity, per the ETF’s listing exchange requirements, for the ETF shares during regular trading hours. Sometimes, the same firm will serve as both an LMM and an AP based on its internal capabilities. In other cases, these functions fall to separate parties.
Many firms with LMM desks have both proprietary trading and agency execution capabilities. These desks buy and sell ETF shares throughout the trading day to make a profit (proprietary trading) or to execute client orders (agency execution). When ETF shares are “sold short” the seller must deliver those shares to the buyer within two days.
If the seller does not have the shares, they must put in a creation order to fulfil this obligation, using an AP to transact with the fund. As detailed above, a creation order can have a minimum unit size of 50,000 shares. A trading firm might wait until they’ve sold 50,000 shares short. Or if, for example, they only need 35,000 shares to fulfill their current T+2 delivery obligations, they might inventory the remaining 15,000 for future needs.
If an LMM firm is a broker-dealer, it might have an AP desk in house. In this case, the in-house desk can create or redeem shares for the other desks as necessary. If an LMM isn’t an AP, it can outsource the AP function to a third-party firm.
APs accommodate the needs of many clients in the ETF capital markets world. Sometimes a smaller player might be a better-suited AP depending on certain factors. Factors might include the nature of the underlying securities or costs associated with using one AP over another.
Relationships and expertise play a large role in how funds choose their LMMs and APs. Relationships generate opportunities and confidence. And while fees are fairly commoditized within the equity world, existing relationships can occasionally provide leverage to negotiate them. In other instances, a fund might place more weight on demonstrated expertise. If a fund has assets in foreign markets, for example, it might be attracted to an AP with experience and expertise in those markets.
To learn more about ETFs and whether they might be right for you, please visit the U.S. Bancorp Fund Services website. For additional information, click here to contact a business development officer in your area.
Mike Castino serves as business development officer for the exchange-traded products division. He joined U.S. Bank in 2013 and has more than 21 years of business development, relationship management, marketing, managerial experience and futures/equity trading experience.