In the most obscure corner of the ETF market, authorized participants, usually broker-dealers, play a critical role by transacting directly with the fund to deliver cash or securities in exchange for ETF shares, and vice versa. They stand in the middle of the market for traders attempting to capture and close an arbitrage,when there is an imbalance in the intraday price of ETF shares relative to the underlying holdings.
Authorized participants also smooth large orders with institutional investors looking to save basis points on a transaction by working as directly as possible with the fund, rather than buying or selling in the open market.
APs, as they are known, are indirectly affected under the new proposal in two ways. First, the rule proposes that ETF issuers standardize and disclose their AP agreements. Second, the ETF would have to disclose daily on its website and before the market opens, the basket of securities with which it will transact, and, in the case of so-called custom or negotiated baskets, these would have to be disclosed daily ex-post once the window for creating or redeeming shares has closed. Additionally, the ability to use custom baskets would now apply to all ETFs.
"Will the use of custom baskets promote a more efficient creation and redemption process?" asked SEC Commissioner Kara Stein in her public remarks when the proposal was announced. "Is the policies and procedures requirement specific enough to prevent wrongdoing, like 'cherry-picking' or 'dumping?' Should we instead only allow custom baskets in certain defined scenarios, and only under specified conditions?"
This part of the rule proposal provides not only more sunlight, but also levels the playing field for issuers of all sizes.
The ETF market appreciates the simplicity in funds setting a single basket for securities or cash going in or out. But custom baskets, which do not necessarily represent a pro rata slice of the fund, can be used in a way that is beneficial to all fund shareholders.
Examples include index transitions or portfolio changes for a transparent, actively managed ETF, which also are covered by the rule. (Notably, the SEC says it will no longer differentiate between index-tracking and actively managed funds, as long as they are transparent.)
"Careful consideration of the scope and parameters of (custom basket) policies and procedures will be a key area of focus for ETF advisers and ETF boards," said Adam Teufel, a Washington-based partner at Dechert LLP. "As stated in the proposing release, the SEC envisions its exam staff reviewing records of custom basket transactions on routine exams, so developing appropriate policies and procedures, and ensuring compliance with those policies and procedures, will be a key area of focus."