Authorized Participant: Definition, Examples, and Benefits

What Is an Authorized Participant?

An authorized participant is an organization that has the right to create and redeem shares of an exchange-traded fund (ETF). The primary function of authorized participants is acquiring the assets needed to create and redeem ETF shares, thus boosting liquidity in the ETF market.

Authorized participants are usually large banks or financial institutions. In addition to maintaining ETF market liquidity, they are also important in aligning ETF prices with their net asset values (NAVs).

By keeping ETF prices close to their NAVs, authorized participants enhance market transparency and encourage the market to function better.

The Role and Function of Authorized Participants

Authorized participants are responsible for acquiring the securities that the ETF wants to hold. If that is the S&P 500 index, they will purchase all its constituents (weighted by market capitalization) and deliver them to the sponsor. In return, authorized participants receive a block of equally valued shares called a creation unit. Issuers can use the services of one or more authorized participants for a fund. Large and active funds tend to have more authorized participants. The number of participants also differs between various types of funds. Equities, on average, have more authorized participants than bonds, perhaps due to higher trading volume.

Traditionally, authorized participants are large banks, such as Bank of America (BAC), JPMorgan Chase (JPM), Goldman Sachs (GS), and Morgan Stanley (MS). They do not receive compensation from a sponsor and have no legal obligation to redeem or create the ETF's shares. Instead, authorized participants are compensated through activity in the secondary market.

Ultimately, both parties benefit from collaborating. The sponsor receives help in creating the fund, while the participant gets a block of shares to resell for a profit. The process works in reverse as well. Authorized participants receive the same value of the underlying security in the fund after selling shares. They earn most of their profits through ETF market arbitrage.

Advantages of Authorized Participants in the ETF Market

The main benefit for investors is that authorized participants keep ETF prices near the net asset values of their underlying securities. Without the authorized participants in the market, ETFs would become more like closed-end funds. In that situation, ETF prices could drift far from net asset values, particularly during large moves up or down. There are numerous examples of closed-end funds that have gone substantially above or below the value of their assets. On the other hand, ETFs generally stay very close to their net asset values.

Consider the difference between the Vanguard Total International Stock ETF (VXUS) and the Eaton Vance Tax-Managed Global Diversified Equity Income Fund (EXG), a closed-end fund. The VXUS ETF was trading at $49.78 on June 22, 2020, while its net asset value was $49.73. That means the VXUS ETF was trading at a premium of $0.05, or about 0.1% of its value. On the same day, the closed-end fund EXG traded at $7.30 per share, even though its net asset value was $8.02. The closed-end fund EXG was trading at a discount of $0.72, which was about 8.98% of its net asset value. In this case, the closed-end fund EXG was hundreds of times further away from its net asset value than the VXUS ETF.

They enhance market transparency by keeping ETF prices close to their net asset values. When most investors buy an ETF, they want to make a bet on a particular asset class. Obviously, someone purchasing a total stock market ETF hopes that stock prices will go up. Typical investors do not want to investigate whether funds are trading above or below their net asset values. However, some long-term value investors prefer closed-end funds precisely because of the occasional opportunity to find steep discounts. As a practical matter, authorized participants ensure that premiums and discounts never get too large in the ETF market.

Having multiple authorized participants improves an ETF's liquidity. Competition tends to keep the fund trading close to its fair value. More importantly, additional authorized participants encourage a better functioning market. When one party ceases to act as an authorized participant, others will see the ETF as a profitable opportunity and offer to create or redeem shares. At the same time, the impacted authorized participant has the option to address any internal issues and resume primary market activities.

The Bottom Line

An authorized participant creates and redeems ETF shares to maintain liquidity in the ETF market. Large banks or financial institutions typically serve as authorized participants, such as Bank of America, JPMorgan Chase, Goldman Sachs, and Morgan Stanley.

Authorized participants have a market impact by keeping ETF prices aligned with their net asset values (NAVs). This aids the accuracy and transparency of the ETF market, and having multiple authorized participants for an ETF enhances market liquidity and functionality.

ETFs would be more like closed-end funds were it not for authorized participants. They keep ETFs from diverging significantly from their NAVs, unlike some closed-end funds.

The profit for authorized participants lies in arbitrage opportunities in the ETF market.