As retail investors, we can take things for granted at times. While ETFs have democratised investing for the main street investors, investing/trading in ETFs would not be possible if not for the market participants greasing the wheels behind the scenes.
More specifically, I am referring to the creation and redemption process of ETFs’ shares. In this article, I will highlight the key roles that market makers and authorized participants have within the ETF industry and how they shaped the ETF trading process.
ETFs’ Liquidity & Markets
Liquidity is the ease of conversion from cash to asset securities and vice versa. In the ETF land, there are two forms of liquidity. First is the liquidity of the ETF itself. Second is the liquidity of the underlying holdings of the ETF. Also known as the underlying liquidity.
In general, underlying liquidity is more important. An ETF which has poor liquidity in itself but has very liquid underlying holdings, should not pose an issue to an investor making a huge trade. I will explain this phenomenon further into the article.
Bond ETFs are unique creatures, especially in the high-yield space where the underlying holdings of the high-yield bond ETFs do not trade much yet the ETF itself can be very liquid.
An example of a high-yield bond ETF is HYG.
Liquidity is often measured by the bid-ask spread. Bid-ask spread or simply the spread, is the difference between the highest price that a buyer is willing to buy at and the lowest price that a seller is willing to sell at. If you are selling, you will look at the bid price and conversely if you are buying, you will look at the asking price. The spread is a trading cost that you should take into consideration.
The more liquid the ETF, the tighter the spread.
Most broad-market or total-market ETFs are extremely efficient and liquid. Therefore, the spread on them is very tight.
Once again, in the ETF land, the markets are split into primary market and secondary market. The primary market is where securities are created and redeemed, and the secondary market is where investors buy and sell securities that they already own.
As far as we are concerned, the retail investors, we are in the secondary market.
Participants in the ETF industry
Fund Issuers / ETF Sponsors
This is pretty straightforward. Fund issuers are the parties that issue/launch the funds. Fund issuers determine the;
- Funds’ objectives
- Funds’ total expense ratios
- On which exchange to list the funds
- Types of benchmarks to use
- Which benchmark issuer to use
- Whether to conduct securities lending
- Which Authorized Participants to appoint for the creation and redemption of the ETFs’ shares, and etc….
Market Makers / Liquidity Provider
Market makers/liquidity provider are broker-dealers who provide regular bid-ask quotes to the clients and investors. They are one of the two parties that provide liquidity in the market. Market makers are generally associated with secondary market liquidity.
Authorized Participants (AP)
APs are parties appointed by the ETF sponsors to create and redeem the ETFs’ shares when there is an imbalance of orders to buy and/or sell the ETFs’ share that cannot be fulfilled in the secondary market.
APs are generally associated with primary market liquidity.
Once again, this is pretty self-explanatory.
Authorized Participants (APs)
While the presence of market makers are essential to ensure that there are ample secondary market liquidity, the role of APs is even more critical as they are the parties behind the scene to ensure that, in the event of illiquidity in the secondary market, they will step in to pump liquidity by creating/redeeming shares in the primary market.
The diagram below depicts the trading process between the market makers, investors, APs and ETF sponsors.
One of the key benefits to the investors as a result of an APs’ presence is lower cost. If an institutional investor seeks to purchase a huge order of an ETF’s shares, it can turn to an AP to facilitate the creation, instead of placing the huge order on the secondary market which may potentially distort/widen the bid-ask spread as a result of the size of the order.
A widening in the spread simply translates to a higher trading cost.
What incentivize APs to do what they do?
APs and market makers are two distinct roles, while distinct, a financial firm can be both the AP and the market maker. However, there are also market makers that purely function as a market maker and APs that purely function as an AP.
APs do not receive financial benefits from the ETFs’ sponsors and have the right but not the legal obligation to create and/or redeem the ETF’s share. So why would they do what they do?
When there is a deviation between the trading price of an ETF and its NAV, this provides an arbitrage opportunity for the APs. When an ETF’s price is trading above/below its NAV, the ETF is said to be trading at a premium/discount respectively.
For example, when an ETF is trading at a premium, i.e. the price of the ETF is higher than the value of all the underlying holdings in the ETF, the AP can either
- Buy all the underlying securities in the secondary market and package it into the ETF
- Deliver all the underlying securities that are on their books and package it into the ETF
- A mixture of the two above
to deliver the ‘mispriced’ ETF to the investors. This allows the AP to profit from the inefficient pricing of the ETF.
Would APs arbitrage even if they can?
While such arbitrage operation sounds simple on paper is often difficult to execute in reality unless you have sophisticated systems/infrastructures in place.
Even if there is an opportunity for arbitrage to take place, an AP may not execute on it if the trading costs associated with executing the arbitrage operation exceed the financial benefits of the arbitrage opportunity.
Furthermore, while efficient ETFs tend to trade very close to its NAV, some ETFs intrinsically will be trading at a premium or discount. One such example is international equity (IE) ETFs that holds securities across the globe. IE ETFs that are listed on the US exchanges that hold securities that are trading on the Asian markets tend to be trading either at a premium or discount. Development in the US market may cause the said Asian securities to deviate from their last closing price and therefore causes the trading price of the IE ETFs to deviate from its NAV resulting in the premiums/discounts.
What are the risks associated with APs & Market Maker?
Since the ETF industry is heavily reliant on market makers and APs to grease the wheels of the trading process, the next natural question would be what would happen when APs and market makers withdraw from the market?
APs have no legal obligation to create and/or redeem the ETFs’ shares. APs are in the market for financial/economic interest. They are not here to make sure that you achieve your financial goals!
One of the key concerns raised by Financial Stability Board (FSB) — a US financial regulatory board, is that in the event of a turbulent market condition, APs may withdraw from the market which creates significant premiums/discounts and will have a negative effect on trading.
However, the process is self-correcting.
In the event of one to a couple of APs withdrawing from the market resulting in significant premiums/discounts, the very presence of the premiums/discounts will incentivize other APs to enter into the market to arbitrage the premiums/discounts such that the price of the ETF will be traded back to its NAV, or at least close to its NAV. This process will close out the presence of significant premiums/discounts.
What if all the APs withdraw at once?
Well, tough luck…..
The creation and redemption process of adjusting the ETFs’ shares in response to the demand and supply will be frozen temporarily. This will also mean that the supply of the ETFs will be fixed in the short-run similar to a closed-end fund.
In this scenario, the price of the ETF would be determined by the exchange based on demand and supply. Similar to closed-end funds, the ETF’s price could be trading either at a premium or discount to its NAV.
Once again, the economic interest of arbitraging would entice APs back into the market. It is very unlikely that significant premiums and/or discounts will remain in the market for an extended period of time.
ETFs that attract arbitrage & APs
In the United States, there are approximate 2300 ETFs listed on the various stock exchanges. Some of the largest ETFs by assets under management in the US attracts so much volume such that there will be natural buyers and sellers for most of the time.
‘Natural transaction’ with natural buyers and sellers is one where trades are executed without the intervention of the market makers and/or authorized participants. ETFs such as SPY, EEM attracts so much volume such that when a retail investor is buying the said securities, chances are the opposite trade (sell-side) is filled by another investor. Such ETFs would also have very tight spreads.
Market makers and APs are the buyers and sellers of the last resort. They will buy when no one is buying and they will sell when no one is selling.
When an ETF has poor liquidity in itself and poor underlying liquidity, there is a good chance that the ETF’s trading price is not closely aligned to its NAV, which in turn translate to the presence of premium/discount. This may attract APs to come into the market to arbitrage the premium/discount away.
What happens when an ETF has poor liquidity in itself but has excellent underlying liquidity?
When an institutional investor wants to place a large order for an ETF that has poor liquidity but has excellent underlying liquidity, the institutional investor can approach the AP for shares creation rather than placing the order in the secondary market which may cause the spread to widen.
In this scenario, the creation process will be relatively smooth for the AP since the underlying holdings are very liquid and therefore the cost of creation will not be as high as compared to securing less liquid holdings.
At the end of the day…..
While APs and market makers are in the market for their own economic/financial interest, they serve a very important role to ensure that the market can function properly.
As always, take personal responsibility of your financial well-being and do your own due diligence.
Disclaimer: This article does not constitute a solicitation to buy/sell any securities that may be mentioned in this article. At the time of writing and publication, the author does not hold any position in any of the securities mentioned in this article. I am writing in my personal capacity and my views do not represent that of any organisations.