Authorised Participants play a critical role in ETP liquidity: Who are they and what do they do?
Authorised participants (APs) are one of the major parties at the center of the ETP creation and redemption mechanism and, as such, play a critical role in ETP liquidity.
In essence, APs are ETP liquidity providers that have the exclusive right to change the supply of ETP shares on the market. When they spot a shortage of ETP shares in the market, they create more shares. Conversely, when there’s an excess supply of ETP shares on the market, they reduce the number of shares by way of the creation and redemption mechanism.
(If you’re not already familiar with this mechanism, see “Creations And Redemptions” for more information.)
APs also often act as market makers for an ETP—standing ready to buy and sell shares of an ETP as investors trade. So, to be clear, APs can perform much of the same function as a market maker, but only APs (and not market makers) can change the supply of ETP shares.
How do APs gain the exclusive right to change the supply of ETP shares?
ETP issuers decide. Prior to launch, the issuer will designate one or more AP to the fund. In some cases, the issuer can even act as the AP for their own funds.
How do APs impact liquidity?
The best way to think about APs in the ETP marketplace is as tamps or valves. Their ability to create and redeem shares of the ETP enables them to control the supply of ETP shares on the market. While any party can act as a market maker or liquidity provider, only APs can control share supply.
For example, if demand for an ETP increases and a premium develops, APs step in to create more shares and push its price back in line with its actual value. If there’s a rush to sell and a discount develops, they buy ETP shares on the open market and redeem with the ETP issuers to reduce supply. (For more information about that process, see “Creations and Redemptions.”)
Generally, the greater the number of APs for a particular ETP, the better: The force of competition is more likely to keep the ETP trading close to its fair value.
There’s also a quality aspect to consider with APs. 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 ETP shares is illiquid or just difficult to access.
The AP’s ability (or skill) to access that market directly affects the liquidity of the ETP all the way down to the quotes and spreads that end-investors see when trading the ETP. Still, the AP assigned to a fund is rarely a decisive factor in selecting an ETF.
An ETP that has an underlying basket of British companies is easy to access and easily hedge-able for most APs, so there’s not much risk in selecting a specific AP. However, the more nuanced or esoteric an ETP’s underlying securities, the more important it becomes to have the right parties act as APs. Consider a fund like the db-X trackers FTSE Vietnam ETF (LSE: XVTD/XFVT). The Vietnamese equity market is significantly less liquid than more developed markets, and may require an AP with more specialised experience.
The takeaway here is that while the work that APs do is critical to ETP liquidity, most of it is behind the scenes.