Authorized participants (APs) are one of the major parties at the center of the ETF creation/redemption mechanism and as such, play a critical role in ETF liquidity.
In essence, APs are ETF liquidity providers that have the exclusive right to change the supply of ETF shares on the market. When they spot a shortage of ETF shares in the market, they create more shares. Conversely, when there’s an excess supply of ETF shares on the market, they reduce the number of shares by way of the creation and redemption mechanism. (See “What Is The Creation/Redemption Mechanism?” in the Related Lessons.)
How do APs gain the right to change the supply of ETF shares?
ETF issuers decide. Prior to launch, the issuer will designate one or more AP to the fund. More can sign up over time. The most popular ETFs will have dozens of APs.
How do APs impact liquidity?
An AP’s ability to create and redeem shares helps keep ETFs priced at fair value.
For example, if demand for an ETF increases and a premium develops, APs step in to create more shares and push the ETF’s price back in line with its actual value. If there’s a rush to sell and a discount develops, APs buy ETF shares on the open market and redeem with the ETF issuers to reduce supply.
Generally, the greater the number of APs for a particular ETF, the better: The force of competition is more likely to keep the ETF trading close to its fair value.
The task set forth for an AP is not necessarily an easy one: Sometimes the underlying market that they must access to change the supply of ETF shares is illiquid, or just difficult to access. An ETF tracking the S&P 500 will be easy to access and easily hedge-able for most APs, while one tracking Nigeria equities will be tough.
Mostly, APs are invisible to individual investors and advisors. Still, it’s good to know they’re there.
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.