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Authorised participants are integral to how exchange traded funds work because they create and redeem shares in ETFs, not only ensuring that they track the prices of the underlying securities, but also playing a critical role in ETF liquidity.
They transact directly with the ETF provider in what is known as the primary market and are solely responsible for changing the supply of ETF shares in the market. When there is a shortage of ETF shares, authorised participants create more. When the price of the ETF moves below the price of the underlying securities the authorised participant will take ETF shares out of the market and return them to the ETF provider. This so-called creation redemption mechanism keeps the price of the ETF aligned with its underlying net asset value.
Who are authorised participants and how do they differ from market makers?
Authorised participants are traditionally the large investment banks such as Morgan Stanley, Goldman Sachs and Bank of America. Although they have no legal obligation to operate in the primary market, it is advantageous for them to do so because they can make money through arbitrage.
Market makers are broker-dealers who provide liquidity in the secondary market, which is where investors buy and sell ETFs. Some are specialised electronic traders. While many market makers are also authorised participants, not all market makers have the ability to create and redeem shares.
Why is it important to understand what APs and market makers do?
Both authorised participants and market makers play an important role in ensuring buy and sell demands are met. Authorised participants’ activities help keep the price of an ETF in line with its net asset value.
APs will act as the counterparty of last resort, allowing investors to buy and sell ETF shares even when volumes dry up. Large ETFs that follow a broad market, such as the S&P 500, are likely to have a large number of authorised participants. Niche funds that track a narrower group of companies will have a smaller number of APs that might have specialised trading skills in the particular securities.
The simultaneous presence of many APs is beneficial for investors, because the competition will result in lower spreads between the ETF share price and net asset value.
What happens if authorised participants withdraw from the market?
Policymakers have expressed concern over the potential impact of the withdrawal of authorised participants from the ETF market during a period of market turmoil. ETF providers counter that if the fund were to trade well below the value of the underlying securities for any period of time, an AP could buy shares in the ETF and redeem them for a profit.
However, there have been occasions when there appears to have been little interest in trading a particular ETF, causing spreads to widen and a dislocation between the price of the ETF and its underlying securities. This is believed to have happened during the trading of high-yield bond ETFs during the market turmoil in March 2020.
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There were advantages to this. The Bank of England pointed out in a recent report into how markets fared during the Covid-19 crisis that the divergence from NAV actually aided price discovery for the underlying bonds.
But the European Systemic Risk Board noted in a report published in May that the divergence from NAV “may have reflected frictions in the ETF intermediation chain, as authorised participants would normally align prices through an arbitrage mechanism”.
It added: “Low levels of liquidity in the underlying assets may have hindered this arbitrage mechanism, which normally closes such spreads, as ETF prices internalise the low level of liquidity in the underlying bonds”.
It noted that at the beginning of April the Federal Reserve announced its intention to include corporate bond ETFs in its asset purchase programme, which led to a reduction in NAV spreads. It did not speculate on what would have happened had the Fed not intervened.
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