Authorised participants and market makers – Part 1

Exchange traded funds (ETFs) have grown quickly in both size and scope over the past decade. Globally, assets under management accelerated from US$675 billion in 2008 to US$8.4 trillion in the first quarter of 2021.¹ Today, over 270 issuers offer more than 7,000 ETFs.²

Many players help support the mechanism that enables ETFs to operate efficiently. We examine two institutions—authorised participants (APs) and market makers—that play central roles in ensuring that ETF prices are accurate, and that trading is smooth, in all market conditions.

ETFs: A unique fund structure

ETFs combine features of managed funds and stocks. Like managed funds, ETFs are pooled investment vehicles that offer access to a broad mix of stocks, bonds or other assets. Unlike managed funds, ETF investors don’t interact directly with the fund provider when buying or selling fund shares. Instead they generally trade existing ETF shares with each other during market hours, on an exchange, just like trading stocks.³

Uniquely, ETFs operate in two markets that involve different types of market participants. Most trading usually occurs in the “secondary” market, or on-exchange, where investors buy and sell existing ETF shares. The price of the shares is determined in real-time and, as with stocks, transaction costs are affected by the ETF’s bid/ask spread (the difference between the buyer and seller prices). Larger, more frequently traded ETFs generally have tighter spreads, and thus lower transaction costs.⁴

A separate, “primary” market involves large institutions (authorised participants) transacting with ETF issuers to create or redeem ETF shares based on market demand. Individual investors do not participate in the primary market. In terms of volume, ETF trading in the primary market is generally less than ETF trading in the secondary market.

Authorised participants (APs): Key players in ETF creations and redemptions

An AP is a financial institution, often a bank, that dynamically manages the creation and redemption of ETF shares in the primary market. This process adjusts the number of ETF shares outstanding and helps keep an ETF’s price aligned with the value of its underlying securities.

Each AP has an agreement with an ETF issuer that gives it the right (but not the obligation) to create and redeem ETF shares. APs may act on their own behalf or on behalf of market participants, and are not compensated by ETF issuers.

Examples of APs include Merrill Lynch, J.P. Morgan and Citigroup.

Market makers: Matching buyers and sellers

A market maker is a broker-dealer that regularly provides two-sided (buy and sell) quotes to clients.⁵ Market makers are key liquidity providers in the ETF ecosystem that ensure continuous and efficient ETF trading in the secondary market.

The role of a market maker is distinct from the role of an AP, though both are necessary for robust ETF trading activity. A market maker does not need to be an AP, nor does an AP need to be a market maker. Still, some firms play both roles in certain ETFs.

Examples of market makers include Susquehanna, Jane Street and JP Morgan.

ETF trading in action

APs and market makers have an economic incentive to take advantage of arbitrage opportunities in the market. This involves trading the ETF shares or underlying securities when there are small price differences between the two.

A market maker may engage an AP to initiate a creation if the price of an ETF share is greater than the value of the underlying holdings (at a premium) or a redemption if the price of an ETF share falls below the value of the underlying holdings (at a discount).

For example, assume that when the market opens, the price of an ETF and the value of its underlying securities are both $100. If the value of the underlying securities falls to $99 while the price of the ETF remains $100 (i.e., the fund is trading at a premium), an AP could profit by creating new ETF shares. Specifically, the AP could buy the underlying securities for $99, deliver them to the ETF issuer to create shares of the ETF and sell the ETF shares at the market price of $100. This results in a profit of $1 per share for the AP.

Likewise, if the market price of the ETF falls to $99 while the value of underlying securities remains $100 (i.e., the fund is trading at a discount), an AP could buy shares of the ETF and redeem them with the issuer in exchange for the fund’s underlying securities, resulting in a profit of $1 per share for the AP. ⁶

The ability to exchange the ETFs for either cash or the underlying assets provides economic incentives for market makers to trade when the price deviates from the value of the underlying assets. This self-policing mechanism ensures the exchange price does not materially deviate from the values of the fund’s assets. Any drifting in the price of an ETF away from the current value of the ETF’s portfolio of securities will economically incentivise market makers due to the fact that profit (as described above) can be made by selling the higher-priced asset while simultaneously buying the lower-priced asset. We term this the “ETF arbitrage mechanism”

Authorised participants transact in the primary market

APs dynamically adjust the number of ETF shares outstanding, and in doing so, increase efficiency and reduce costs for ETF investors.

When demand for ETF shares exceeds the supply of shares available in the market, APs work with ETF providers to create additional shares.

An AP can initiate a creation in three ways:

1. Deliver a “creation basket,” or a pre-specified bundle of securities representing the underlying index, to the ETF issuer
2. Provide cash equal to the full or partial value of the creation basket (including actual trading costs of purchasing the creation basket) to the ETF issuer.
3. Provide cash equal to the value of the ETF shares plus a trading spread (a buy/sell spread) to the issuer⁷

In return, the ETF issuer will deliver new shares of the ETF to the AP. The AP can then hold these shares in their inventory or sell them to investors in the secondary market.

Conversely, when there are too many ETF shares outstanding due to more investors selling shares than buying shares in the secondary market (i.e., supply is exceeding demand), an AP will buy ETF shares on the exchange and return them to the ETF issuer.

To initiate a redemption, the AP must deliver ETF shares—either obtained from inventory or purchased on the secondary market—to the ETF issuer. Once ETF shares are delivered, the ETF issuer gives the AP a “redemption basket”, or cash, in return^.8

To initiate a redemption, the AP must deliver ETF shares—either obtained from inventory or purchased on the secondary market—to the ETF issuer. Once ETF shares are delivered, the ETF issuer gives the AP a “redemption basket”, or cash, in return.8

ETFs and managed funds: Know the differences

• Strategy: Fund management styles are typically categorized as “active” or “index”. Active funds (most managed funds) seek to outperform market indexes, while “index” funds (some managed funds and most ETFs) seek to match the fund’s performance to an established market index, such as the S&P/ASX 200.
• Trading: Managed funds are bought and sold directly from the managed fund company at the current day’s Net Asset Value (NAV). ETFs are traded throughout the day at the current market price, like a stock, and may cost slightly more or less than NAV. Managed fund transactions do not include commissions to a brokerage, while some ETF transactions do.
• Transaction fees: For managed funds, transaction fees may include a a buy/sell spread and other charges (such as platform fees) These are paid by investors. ETF transactions may include brokerage commissions (like stocks), which are paid directly by investors.
• ManagedTransparency: ETFs generally disclose holdings daily. Managed funds generally disclose holdings quarterly.
• Cost: The management fee of ETFs is generally significantly lower than an actively managed fund invested in the same assets. As it is a collection of shares/bonds or commodities, the cost of trading in and out of ETFs is lower than buying the underlying securities individually.