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The exchange-traded fund (ETF) market operates on a foundation most investors never see: the creation-redemption process.
ETF authorized participants — specialized financial institutions that act as a link between ETF issuers and the market — are at the heart of this process. If you’re an asset manager launching or managing an ETF, understanding the nuances of the authorized participant relationship is critical for your fund’s success and liquidity.
Here’s everything asset managers need to know about ETF authorized participants, from how they function to what to consider when selecting and managing them.
Authorized participants (APs) are financial institutions that sign an agreement with ETF distributors, granting them the exclusive right to create and redeem shares for specific ETFs. These signed agreements outline the terms, responsibilities, and fee structures that govern the relationship.
APs have several key responsibilities:
Acting as primary market dealers: They exchange baskets of securities with the ETF provider for blocks of new ETF shares (creation units), typically in blocks of 50,000 shares.
Meeting market supply and demand: When investor demand for an ETF increases, APs execute the necessary trades to create new shares and bring them to market.
Maintaining liquidity: APs keep an ETF’s market price as close as possible to its net asset value (NAV), which is essential for investor protection and market efficiency.
Enabling faster response times: While most ETF trading occurs in the secondary market during the trading day, APs can quickly create new shares when market supply cannot meet demand.
Providing tax efficiency: APs help ETFs avoid realizing capital gains that would otherwise be distributed to shareholders, providing a significant advantage over mutual funds.
While related, APs and market makers have different duties.
Market makers:
Authorized participants:
It’s worth noting that some APs are also market makers. Many large financial institutions play both roles, which can enhance ETF liquidity.
Authorized participants buy the securities in the ETF’s portfolio, then form a creation basket. That creation basket goes to the ETF issuer, and the AP receives a new creation unit in return. APs can also purchase creation units with cash rather than by exchanging actual securities.
The reverse process uses redemption baskets. When APs redeem creation units, they receive baskets of the underlying securities from the issuer.
Here’s a step-by-step breakdown of the creation process:
Understanding this process helps you anticipate when creations will occur and plan for the operational requirements. Work with your APs to establish procedures for basket delivery timing, settlement protocols, and communication.
Here’s how redemption works, from start to finish:
Redemptions can signal investor outflows or broader market stress, so monitoring redemption patterns helps you understand fund health. If redemptions suddenly spike, communicate with your APs to make sure they have the operational capacity to handle higher activity.
APs can use both in-kind and cash transactions.
In-kind transactions are preferred for most equity ETFs, as they maximize tax efficiency. These transactions avoid fund-level capital gains and are often cheaper and faster to execute.
Cash transactions tend to be preferred in fixed-income ETFs, international markets with settlement challenges, and certain commodities ETFs. Cash is better suited for complex assets but can lead to tracking errors.
One of the most important benefits APs provide is tax efficiency. Through in-kind transactions, APs enable ETFs to minimize or eliminate capital gains distributions to shareholders. When securities are exchanged for ETF shares (rather than sold for cash), no taxable event occurs at the fund level.
This allows ETFs to avoid the capital gains distributions that mutual funds regularly pass through to their individual investors. Asset managers who want to attract tax-conscious investors should prioritize APs experienced in executing efficient in-kind transactions.
Authorized participants are critical to a fund’s ecosystem for several reasons:
By creating a large number of shares in the primary market to meet ETF investor demand in the secondary market, APs serve as stewards of liquidity. Remember: ETF liquidity extends beyond shares outstanding and is primarily determined by the liquidity of the underlying holdings.
Maintaining alignment between an ETF’s market price and its net asset value improves risk management, reduces arbitrage opportunities, and protects client investments. Typical tracking spreads are measured in basis points during normal market conditions. APs can act quickly to handle arbitrage situations and keep an ETF in line with its NAV.
When ETF shares trade at a premium or discount to NAV, AP arbitrage activity eliminates these discrepancies and ensures the price of the ETF share trades at fair value relative to the underlying assets.
In stressed market conditions, APs can tilt redemptions toward underlying assets with less liquidity to stabilize the fund. This capability is critical during times of market duress and volatility.
While APs are essential to ETF functionality, they face limitations, especially during market stress. Asset managers who understand these constraints can better prepare for periods of volatility.
The pandemic created enormous stress on financial markets in March 2020. Fixed-income ETF premiums and discounts widened significantly, and APs worked to stabilize pricing in response. However, many funds experienced temporary dislocations.
The market normalized within weeks, demonstrating the AP system’s resilience as well as its limits.
APs must sometimes reduce their creation and redemption activity due to:
Non-transparent or semi-transparent ETF structures can affect AP behavior, too. Semi-transparent ETFs often use a proxy basket of underlying securities, which may reduce an AP’s willingness to create or redeem shares compared to fully transparent structures.
When investors rapidly sell off securities, it can create a liquidity cascade where APs struggle to sell the underlying securities of an ETF. Any market stress that makes securities more challenging to trade can create issues for the creation-redemption process.
If you’re an asset manager who’s choosing an AP for your ETF, here’s what you need to know.
Look for authorized participants with these qualities:
ETFs can have twenty to thirty authorized participants, but usually only a handful create and redeem shares. ETFs with more assets under management (AUM) and foreign underlying securities typically require more APs than funds with fewer assets.
A larger number of APs can help maintain liquidity, but quality matters more than quantity. Two to three highly engaged APs can outperform twenty disengaged ones.
The ideal approach: Start with a few committed APs and expand as the ETF grows. For international ETFs, ensure you have APs based in multiple time zones.
As you set up your operation agreements, here’s what to consider:
Request a copy of the AP’s agreement template early so your legal team can review it well before you prepare to launch. Many provisions are negotiable even if they appear standardized, especially fee structures, basket customization rights, and cutoff times.
Be wary of red flags like one-sided error liability or a lack of clear dispute-resolution procedures. It’s best to seek out relationships with APs who demonstrate flexibility and a willingness to understand your specific asset class needs.
Consider the typical fee for each creation-redemption transaction. Fees may vary based on factors like:
Conduct a break-even analysis: At what AUM do creation-redemption economics make sense? Factor AP fees into your expense ratio projections and decide whether you’ll absorb those costs during launch or pass them through.
Here are some tips for successfully managing an ongoing relationship with an authorized participant:
Document all interactions, performance data, and issues in a centralized system your entire team can access, ensuring access to objective data for strategic planning.
When it comes to regulatory concerns, asset managers must address:
Also, make sure you have a clear workflow for approvals:
Missing these steps can create regulatory deficiencies. Put together a checklist that covers legal reviews, board reviews, and disclosure updates. Update Form N-1A when adding APs or making material changes.
Watch for these warning signs in your AP relationships:
Review AP performance regularly. If a problem arises, document it and address the concern directly with the AP. If performance doesn’t improve after reasonable opportunities to correct course, start building backup relationships so you don’t end up in a situation where terminating a poorly performing AP leaves your fund without options.
Authorized participants are the invisible infrastructure that makes ETFs work. For asset managers, understanding and managing these relationships is critical to fund success.
Remember:
Building and actively managing AP relationships throughout your ETF’s lifecycle will ensure optimal liquidity, pricing, and tax efficiency for your investors.
Need to better understand authorized participant trading patterns? VettaFi provides the market intelligence to optimize these relationships. Contact us today to learn how we can strengthen your AP partnerships.
Yes, but it’s risky. Being dependent on a single authorized participant means that if the participant steps back due to capital constraints, market stress, or other concerns, your ETF has no creation-redemption mechanism. New ETFs with simple asset classes can start with one authorized participant but should add more as they grow.
If all APs stop participating, the ETF effectively becomes a closed-end fund and its share price can diverge significantly from NAV. Without the creation-redemption mechanism, investors can only trade in the secondary market, where spreads widen and liquidity deteriorates. This is rare and typically only occurs during extreme market stress or with very small funds. Asset managers can prevent this by prioritizing financially stable partners and having contingency plans for market volatility.
The "primary market" transaction between the AP and the ETF issuer typically follows the standard T+1 or T+2 settlement cycle (one to two business days after the trade). While the AP and issuer agree on the basket exchange almost instantly, the physical transfer of underlying securities and the delivery of new ETF shares must clear through central clearinghouses like the NSCC.
Yes, authorized participants typically charge transaction fees to cover their operational costs. However, fee structures are negotiable and vary based on your agreement with each authorized participant. Factors like asset class complexity, basket size, and whether transactions are in kind or cash based will impact the amount of the fee. Asset managers should negotiate fees upfront and factor them into the ETF’s overall cost structure.
Non-transparent ETFs use proxy baskets instead of revealing actual holdings to authorized participants. Authorized participants must create and redeem shares based on these representative portfolios rather than the fund’s exact composition, which increases their operational risk and complexity. This typically results in higher fees, wider spreads, and fewer willing participants compared to fully transparent ETFs.
The exchange-traded fund (ETF) market operates on a foundation most investors never see: the creation-redemption process.
ETF authorized participants — specialized financial institutions that act as a link between ETF issuers and the market — are at the heart of this process. If you’re an asset manager launching or managing an ETF, understanding the nuances of the authorized participant relationship is critical for your fund’s success and liquidity.
Here’s everything asset managers need to know about ETF authorized participants, from how they function to what to consider when selecting and managing them.
Authorized participants (APs) are financial institutions that sign an agreement with ETF distributors, granting them the exclusive right to create and redeem shares for specific ETFs. These signed agreements outline the terms, responsibilities, and fee structures that govern the relationship.
APs have several key responsibilities:
Acting as primary market dealers: They exchange baskets of securities with the ETF provider for blocks of new ETF shares (creation units), typically in blocks of 50,000 shares.
Meeting market supply and demand: When investor demand for an ETF increases, APs execute the necessary trades to create new shares and bring them to market.
Maintaining liquidity: APs keep an ETF’s market price as close as possible to its net asset value (NAV), which is essential for investor protection and market efficiency.
Enabling faster response times: While most ETF trading occurs in the secondary market during the trading day, APs can quickly create new shares when market supply cannot meet demand.
Providing tax efficiency: APs help ETFs avoid realizing capital gains that would otherwise be distributed to shareholders, providing a significant advantage over mutual funds.
While related, APs and market makers have different duties.
Market makers:
Authorized participants:
It’s worth noting that some APs are also market makers. Many large financial institutions play both roles, which can enhance ETF liquidity.
Authorized participants buy the securities in the ETF’s portfolio, then form a creation basket. That creation basket goes to the ETF issuer, and the AP receives a new creation unit in return. APs can also purchase creation units with cash rather than by exchanging actual securities.
The reverse process uses redemption baskets. When APs redeem creation units, they receive baskets of the underlying securities from the issuer.
Here’s a step-by-step breakdown of the creation process:
Understanding this process helps you anticipate when creations will occur and plan for the operational requirements. Work with your APs to establish procedures for basket delivery timing, settlement protocols, and communication.
Here’s how redemption works, from start to finish:
Redemptions can signal investor outflows or broader market stress, so monitoring redemption patterns helps you understand fund health. If redemptions suddenly spike, communicate with your APs to make sure they have the operational capacity to handle higher activity.
APs can use both in-kind and cash transactions.
In-kind transactions are preferred for most equity ETFs, as they maximize tax efficiency. These transactions avoid fund-level capital gains and are often cheaper and faster to execute.
Cash transactions tend to be preferred in fixed-income ETFs, international markets with settlement challenges, and certain commodities ETFs. Cash is better suited for complex assets but can lead to tracking errors.
One of the most important benefits APs provide is tax efficiency. Through in-kind transactions, APs enable ETFs to minimize or eliminate capital gains distributions to shareholders. When securities are exchanged for ETF shares (rather than sold for cash), no taxable event occurs at the fund level.
This allows ETFs to avoid the capital gains distributions that mutual funds regularly pass through to their individual investors. Asset managers who want to attract tax-conscious investors should prioritize APs experienced in executing efficient in-kind transactions.
Authorized participants are critical to a fund’s ecosystem for several reasons:
By creating a large number of shares in the primary market to meet ETF investor demand in the secondary market, APs serve as stewards of liquidity. Remember: ETF liquidity extends beyond shares outstanding and is primarily determined by the liquidity of the underlying holdings.
Maintaining alignment between an ETF’s market price and its net asset value improves risk management, reduces arbitrage opportunities, and protects client investments. Typical tracking spreads are measured in basis points during normal market conditions. APs can act quickly to handle arbitrage situations and keep an ETF in line with its NAV.
When ETF shares trade at a premium or discount to NAV, AP arbitrage activity eliminates these discrepancies and ensures the price of the ETF share trades at fair value relative to the underlying assets.
In stressed market conditions, APs can tilt redemptions toward underlying assets with less liquidity to stabilize the fund. This capability is critical during times of market duress and volatility.
While APs are essential to ETF functionality, they face limitations, especially during market stress. Asset managers who understand these constraints can better prepare for periods of volatility.
The pandemic created enormous stress on financial markets in March 2020. Fixed-income ETF premiums and discounts widened significantly, and APs worked to stabilize pricing in response. However, many funds experienced temporary dislocations.
The market normalized within weeks, demonstrating the AP system’s resilience as well as its limits.
APs must sometimes reduce their creation and redemption activity due to:
Non-transparent or semi-transparent ETF structures can affect AP behavior, too. Semi-transparent ETFs often use a proxy basket of underlying securities, which may reduce an AP’s willingness to create or redeem shares compared to fully transparent structures.
When investors rapidly sell off securities, it can create a liquidity cascade where APs struggle to sell the underlying securities of an ETF. Any market stress that makes securities more challenging to trade can create issues for the creation-redemption process.
If you’re an asset manager who’s choosing an AP for your ETF, here’s what you need to know.
Look for authorized participants with these qualities:
ETFs can have twenty to thirty authorized participants, but usually only a handful create and redeem shares. ETFs with more assets under management (AUM) and foreign underlying securities typically require more APs than funds with fewer assets.
A larger number of APs can help maintain liquidity, but quality matters more than quantity. Two to three highly engaged APs can outperform twenty disengaged ones.
The ideal approach: Start with a few committed APs and expand as the ETF grows. For international ETFs, ensure you have APs based in multiple time zones.
As you set up your operation agreements, here’s what to consider:
Request a copy of the AP’s agreement template early so your legal team can review it well before you prepare to launch. Many provisions are negotiable even if they appear standardized, especially fee structures, basket customization rights, and cutoff times.
Be wary of red flags like one-sided error liability or a lack of clear dispute-resolution procedures. It’s best to seek out relationships with APs who demonstrate flexibility and a willingness to understand your specific asset class needs.
Consider the typical fee for each creation-redemption transaction. Fees may vary based on factors like:
Conduct a break-even analysis: At what AUM do creation-redemption economics make sense? Factor AP fees into your expense ratio projections and decide whether you’ll absorb those costs during launch or pass them through.
Here are some tips for successfully managing an ongoing relationship with an authorized participant:
Document all interactions, performance data, and issues in a centralized system your entire team can access, ensuring access to objective data for strategic planning.
When it comes to regulatory concerns, asset managers must address:
Also, make sure you have a clear workflow for approvals:
Missing these steps can create regulatory deficiencies. Put together a checklist that covers legal reviews, board reviews, and disclosure updates. Update Form N-1A when adding APs or making material changes.
Watch for these warning signs in your AP relationships:
Review AP performance regularly. If a problem arises, document it and address the concern directly with the AP. If performance doesn’t improve after reasonable opportunities to correct course, start building backup relationships so you don’t end up in a situation where terminating a poorly performing AP leaves your fund without options.
Authorized participants are the invisible infrastructure that makes ETFs work. For asset managers, understanding and managing these relationships is critical to fund success.
Remember:
Building and actively managing AP relationships throughout your ETF’s lifecycle will ensure optimal liquidity, pricing, and tax efficiency for your investors.
Need to better understand authorized participant trading patterns? VettaFi provides the market intelligence to optimize these relationships. Contact us today to learn how we can strengthen your AP partnerships.
Yes, but it’s risky. Being dependent on a single authorized participant means that if the participant steps back due to capital constraints, market stress, or other concerns, your ETF has no creation-redemption mechanism. New ETFs with simple asset classes can start with one authorized participant but should add more as they grow.
If all APs stop participating, the ETF effectively becomes a closed-end fund and its share price can diverge significantly from NAV. Without the creation-redemption mechanism, investors can only trade in the secondary market, where spreads widen and liquidity deteriorates. This is rare and typically only occurs during extreme market stress or with very small funds. Asset managers can prevent this by prioritizing financially stable partners and having contingency plans for market volatility.
The "primary market" transaction between the AP and the ETF issuer typically follows the standard T+1 or T+2 settlement cycle (one to two business days after the trade). While the AP and issuer agree on the basket exchange almost instantly, the physical transfer of underlying securities and the delivery of new ETF shares must clear through central clearinghouses like the NSCC.
Yes, authorized participants typically charge transaction fees to cover their operational costs. However, fee structures are negotiable and vary based on your agreement with each authorized participant. Factors like asset class complexity, basket size, and whether transactions are in kind or cash based will impact the amount of the fee. Asset managers should negotiate fees upfront and factor them into the ETF’s overall cost structure.
Non-transparent ETFs use proxy baskets instead of revealing actual holdings to authorized participants. Authorized participants must create and redeem shares based on these representative portfolios rather than the fund’s exact composition, which increases their operational risk and complexity. This typically results in higher fees, wider spreads, and fewer willing participants compared to fully transparent ETFs.
