What Is an Authorized Participant?
An authorized participant is an organization that has the right to create and redeem shares of an exchange traded fund (ETF). They provide a large portion of the liquidity in the ETF market by obtaining the underlying assets required to create the shares of an ETF. When there is a shortage of ETF shares in the market, authorized participants create more. Conversely, authorized participants will reduce ETF shares in circulation when the price of the ETF is lower than the price of the underlying shares. That can be done with the creation and redemption mechanism that keeps the price of an ETF aligned with its underlying net asset value (NAV).
Key Takeaways
- An authorized participant is an organization that has the right to create and redeem shares of an exchange traded fund (ETF).
- Traditionally, authorized participants are large banks, such as Bank of America (BAC), JPMorgan Chase (JPM), Goldman Sachs (GS), and Morgan Stanley (MS).
- Authorized participants increase the transparency of markets by keeping ETF prices close to their net asset values.
- Multiple authorized participants help improve the liquidity of a particular ETF.
Understanding Authorized Participants
Authorized participants are responsible for acquiring the securities that the ETF wants to hold. If that is the S&P 500 index, they will purchase all its constituents (weighted by market capitalization) and deliver them to the sponsor. In return, authorized participants receive a block of equally valued shares called a creation unit. Issuers can use the services of one or more authorized participants for a fund. Large and active funds tend to have more authorized participants. The number of participants also differs between various types of funds. Equities, on average, have more authorized participants than bonds, perhaps due to higher trading volume.
Traditionally, authorized participants are large banks, such as Bank of America (BAC), JPMorgan Chase (JPM), Goldman Sachs (GS), and Morgan Stanley (MS). They do not receive compensation from a sponsor and have no legal obligation to redeem or create the ETF's shares. Instead, authorized participants are compensated through activity in the secondary market.
Small investors cannot become authorized participants.
In the end, both parties benefit from working together. The sponsor receives help in creating the fund while the participant gets a block of shares to resell for a profit. This process also works in reverse. Authorized participants receive the same value of the underlying security in the fund after selling shares. Authorized participants make most of their profits in the ETF market through arbitrage.
Benefits of Authorized Participants
The chief benefit of authorized participants for investors is that they keep ETF prices close to the net asset values of the underlying securities. Without the authorized participants in the market, ETFs would become more like closed-end funds. In that situation, ETF prices could drift far from net asset values, particularly during large moves up or down. There are numerous examples of closed-end funds that have gone substantially above or below the value of their assets. On the other hand, ETFs generally stay very close to their net asset values.
Consider the difference between the Vanguard Total International Stock ETF (VXUS) and the Eaton Vance Tax-Managed Global Diversified Equity Income Fund (EXG), a closed-end fund. The VXUS ETF was trading at $49.78 on June 22, 2020, while its net asset value was $49.73. That means the VXUS ETF was trading at a premium of $0.05, or about 0.1% of its value. On the same day, the closed-end fund EXG traded at $7.30 per share, even though its net asset value was $8.02. The closed-end fund EXG was trading at a discount of $0.72, which was about 8.98% of its net asset value. In this case, the closed-end fund EXG was hundreds of times further away from its net asset value than the VXUS ETF.
Authorized participants increase the transparency of markets by keeping ETF prices close to their net asset values. When most investors buy an ETF, they want to make a bet on a particular asset class. Most obviously, someone purchasing a total stock market ETF hopes that stock prices will go up. Typical investors do not want to investigate whether funds are trading above or below their net asset values. However, some long-term value investors prefer closed-end funds precisely because of the occasional opportunity to find steep discounts. As a practical matter, authorized participants ensure that premiums and discounts never get too large in the ETF market.
Multiple authorized participants help improve the liquidity of a particular ETF. Competition tends to keep the fund trading close to its fair value. More importantly, additional authorized participants encourage a better functioning market. When one party ceases to act as an authorized participant, others will see the ETF as a profitable opportunity and offer to create or redeem shares. At the same time, the impacted authorized participant has the option to address any internal issues and resume primary market activities.
As an expert in financial markets and investment strategies, I have a deep understanding of the various mechanisms that drive the functionality of Exchange Traded Funds (ETFs) and the pivotal role played by authorized participants in maintaining market efficiency. I have actively followed the trends and developments in the financial industry, staying abreast of the nuances that characterize the dynamics of ETFs.
Now, delving into the concepts presented in the provided article, let's break down the key elements:
Authorized Participants: The Cornerstone of ETF Functionality
1. Definition:
- An authorized participant is an organization granted the exclusive right to create and redeem shares of an ETF.
- They play a crucial role in maintaining liquidity in the ETF market.
2. Participants and Liquidity:
- Traditionally, authorized participants are major financial institutions such as Bank of America (BAC), JPMorgan Chase (JPM), Goldman Sachs (GS), and Morgan Stanley (MS).
- These entities contribute significantly to market liquidity by facilitating the creation and redemption of ETF shares based on market demand.
3. Creation and Redemption Mechanism:
- Authorized participants are responsible for acquiring the underlying assets of the ETF, ensuring alignment with its net asset value (NAV).
- They create new shares when there is a shortage and redeem shares when the ETF price is lower than the underlying shares, maintaining price alignment.
The Role of Authorized Participants in Fund Creation
4. Securities Acquisition:
- Authorized participants acquire the securities that the ETF intends to hold. For example, for an ETF tracking the S&P 500 index, they purchase the index constituents, delivering them to the sponsor.
5. Creation Units:
- In return for delivering the underlying securities, authorized participants receive creation units, which are blocks of equally valued shares.
6. Number of Participants:
- The number of authorized participants varies among funds, with large and active funds typically having more participants. Equities generally have more participants than bonds.
Mutual Benefits and Profit Mechanisms
7. Compensation and Profits:
- Authorized participants do not receive direct compensation from sponsors but benefit from the secondary market.
- Profits are often derived through arbitrage, as the participants can sell the received shares in the secondary market for a profit.
8. Mutual Benefits:
- Both sponsors and authorized participants benefit from the collaboration. Sponsors get assistance in creating the fund, while participants receive shares for resale.
The Crucial Role in Market Transparency and Liquidity
9. Market Transparency:
- Authorized participants contribute to market transparency by keeping ETF prices closely aligned with their net asset values.
10. Liquidity Improvement:
- Multiple authorized participants enhance liquidity in the ETF market, preventing large deviations from fair value. Competition among participants ensures market efficiency.
In conclusion, authorized participants serve as linchpins in the ETF ecosystem, playing a pivotal role in maintaining market transparency, liquidity, and the overall efficient functioning of ETFs. Their actions ensure that ETF prices closely reflect the values of their underlying securities, benefitting both investors and the financial markets at large.
