Even the transparency-obsessed exchange-traded-fund world has its dark corners. But thanks to reams of fresh regulatory data, some cobwebs have been cleared around the breadth and depth of the authorized participant market.
Authorized participants, primarily banks and brokers, intermediate the flow of securities in to and out of exchange-traded funds by delivering cash or securities to the ETF in exchange for fund shares and vice versa. Any gap between the value of the underlying securities and the ETF shares is captured by the AP, working on its own behalf or as an agent for another investor.
Size and scale are the law of the land in the ETF market. For example, the big three issuers — BlackRock Inc., Vanguard Group Inc., and State Street Global Advisors — manage 86% of the assets in this $4.1 trillion market, according to research firm XTF.
That same dynamic shows up in the AP market with its own big three. According to BlackRock's analysis, units of Bank of America (21%), Goldman Sachs (17%), and ABN AMRO (13%) were responsible for just over half of gross creations and redemptions in U.S.-listed ETFs.
In total, BlackRock found 51 total contracted APs in the U.S. market, with an average of 22 contracted APs per ETF, but only an average of five active APs per ETF. BlackRock defined an "active" AP as one that had either created or redeemed ETF shares in the reporting period.
The data were from the new Form N-CEN, the annual report for investment companies filed to the U.S. Securities and Exchange Commission. Completion of the form has been required since June 2018 after the close of an investment company's fiscal year.
"It's surface-level information," said Ben Johnson, director of global passive research at Morningstar Inc. in Chicago, "but it's materially more than we had previously."
The AP data collected by the SEC details only the gross creations and redemptions by authorized participants on an ETF by ETF basis. Many banks and brokers are both liquidity providers and APs.
"BlackRock has always monitored APs in our own funds," said Samara Cohen, co-head of iShares global markets and investments at BlackRock in New York. "Yet public discussion of the AP market has always been long on speculation and short on facts. I commend the SEC for bringing this public through transparent, structured data."
Several large authorized participants contacted either declined to comment or did not respond to requests for comment.
One of the more revealing aspects of the data is the role that subsidiaries of large European financial institutions play in the U.S. ETF market. ABN AMRO Securities (USA) LLC, SG Americas Securities LLC, Deutsch Bank Securities Inc. and BNP Paribas Securities Corp. are among the top 10 in gross creation/redemption activity. Among the top firms by ETF coverage, five of the top 11 by contracted and active tickers were European banks.
"The AP business is operationally intensive, particularly for international funds, where you need accounts and operations in those countries," said Ms. Cohen. "If you have global breadth of business and operations, you are able to cover a wider swath of funds as an AP."
While APs are crucial to ETF operations, primary market activity (creations/redemptions) is only one-fifth the size of the traditional, or secondary, market for trading in ETF shares, according to BlackRock.
"The way most investors experience the health of the ETF ecosystem is in tracking error (for index-based ETFs) and market health as represented by premiums/discounts to NAV and trading spreads," said Ms. Cohen.
Missing in the data is what compels an authorized participant to create or redeem shares: Was there a creation/redemption request from a client? Was the arbitrage wide enough? Do they specialize in a particular area of the market?
"There's nothing that requires an AP to transact, but what underscores the entire market is the APs ability to identify an arbitrage and trade on it," said Ryan Sullivan, senior vice president, global ETF services, at Brown Brothers Harriman & Co. in Boston. "They earn a profit on that trade, but it also serves to narrow any premium/discount between the ETF shares trading on the secondary market and the NAV."
Mr. Sullivan said that a marketwide view of APs can skew toward the existing relationships of the largest ETF issuers. For example, BlackRock has 29 actives APs among 48 contracted; Vanguard has 22 out of 22 active; SSGA has 27 of 37 active, and Invesco has 25 of 42 active.
Newer funds and issuers, however, "may only have two or three APs when they launch," said Mr. Sullivan. Among factors that APs consider before signing on for a particular ETF are the robustness of the derivatives market tied the ETF's exposure, the potential carrying cost of the ETF and its underlying securities, as well as the balance sheet impact for the financial institution.
