Authorized Participant

The Definition in SEC Rule 6c-11

Under Rule 6c-11(a)(1), authorized participant means a member or participant of a clearing agency registered with the Commission, which has a written agreement with the exchange-traded fund or one of its service providers that allows the authorized participant to place orders for the purchase and redemption of creation units.

The authorized participant is also part of the definition of the fund itself. Under Rule 6c-11(a)(1), exchange-traded fund means a registered open-end management company that issues, and redeems, creation units to, and from, authorized participants in exchange for a basket and a cash balancing amount if any, and whose shares are listed on a national securities exchange and traded at market-determined prices.

Under Rule 6c-11(a)(1), creation unit means a specified number of exchange-traded fund shares that the exchange-traded fund will issue to, or redeem from, an authorized participant in exchange for the deposit, or delivery, of a basket and a cash balancing amount if any.

Terms Used in the Definition

The definition of authorized participant uses the term clearing agency. Under section 3(a)(23)(A) of the Securities Exchange Act of 1934, the term clearing agency means any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities or who provides facilities for comparison of data respecting the terms of settlement of securities transactions, to reduce the number of settlements of securities transactions or for the allocation of securities settlement responsibilities.

Under the same subparagraph, the term also means any person, such as a securities depository, who (i) acts as a custodian of securities in connection with a system for the central handling of securities whereby all securities of a particular class or series of any issuer deposited within the system are treated as fungible and may be transferred, loaned, or pledged by bookkeeping entry without physical delivery of securities certificates, or (ii) otherwise permits or facilitates the settlement of securities transactions or the hypothecation or lending of securities without physical delivery of securities certificates.

The definition of authorized participant also refers to a written agreement with the exchange-traded fund or one of its service providers. Under Rule 6c-11(a)(1), the agreement allows the authorized participant to place orders for the purchase and redemption of creation units.

Under Rule 6c-11(a)(1), basket means the securities, assets or other positions in exchange for which an exchange-traded fund issues, or in return for which it redeems, creation units.

Under Rule 6c-11(a)(1), cash balancing amount means an amount of cash to account for any difference between the value of the basket and the net asset value of a creation unit.

Under Rule 6c-11(a)(1), custom basket means a basket that is composed of a non-representative selection of the exchange-traded fund’s portfolio holdings, or a representative basket that is different from the initial basket used in transactions on the same business day.

Who Authorized Participants Are

An ETF does not sell individual shares directly to, or redeem individual shares directly from, retail investors. Authorized participants that have contractual arrangements with the ETF (or its distributor) purchase and redeem ETF shares directly from the ETF in blocks called creation units.

An ETF enters into contracts with financial institutions, typically large broker-dealers, to act as authorized participants. The definition in Rule 6c-11(a)(1) refers to a member or participant of a clearing agency registered with the Commission.

Authorized participants purchase and redeem shares directly with the ETF in the primary market in large blocks of shares called creation units. Authorized participants typically sell some or all of their ETF shares in the secondary market, on an exchange. This enables investors to buy and sell ETF shares like the shares of any publicly traded company.

How an Authorized Participant Creates ETF Shares

An authorized participant that purchases a creation unit of ETF shares directly from the ETF deposits with the ETF a basket of securities and other assets identified by the ETF that day, and then receives the creation unit of ETF shares in return for those assets.

The basket is generally representative of the ETF’s portfolio, and together with a cash balancing amount, it is equal in value to the aggregate net asset value of the ETF shares in the creation unit.

Authorized participants typically pay for creation units in an in-kind exchange with a group or basket of securities and other assets that generally mirrors the ETF’s portfolio.

After purchasing a creation unit, the authorized participant may hold the individual ETF shares, or sell some or all of them in secondary market transactions. Once the authorized participant receives the ETF shares, the authorized participant is free to sell the ETF shares on a national stock exchange to retail investors, institutions, or market makers in the ETF. Investors then purchase individual ETF shares in the secondary market.

How an Authorized Participant Redeems ETF Shares

The redemption process is the reverse of the creation process. An authorized participant buys a large block of ETF shares on the open market and delivers those shares to the fund. In return, the authorized participant receives a pre-defined basket of individual securities, or the cash equivalent.

ETF shares generally are redeemable in kind. An ETF may deliver specified portfolio securities to authorized participants who are redeeming creation units instead of selling portfolio securities to meet redemption demands, which could otherwise result in taxable gains to the ETF.

Principal and Agent Capacity

An authorized participant may act as a principal for its own account when purchasing or redeeming creation units from the ETF.

Authorized participants also may act as agent for others, such as market makers, proprietary trading firms, hedge funds or other institutional investors, and receive fees for processing creation units on their behalf.

Market makers, proprietary trading firms, and hedge funds provide additional liquidity to the ETF market through their trading activity.

Hedging and Arbitrage

An ETF’s market price typically will be more or less than the fund’s NAV per share, which is called selling at a premium or discount. Under Rule 6c-11(a)(1), premium or discount means the positive or negative difference between the market price of an exchange-traded fund share at the time as of which the current net asset value is calculated and the exchange-traded fund’s current net asset value per share, expressed as a percentage of the exchange-traded fund share’s current net asset value per share.

Arbitrage is the practice of taking advantage of a price differential between two or more markets. Authorized participants can arbitrage a difference between the market price and the NAV per share, and make a profit, because they can trade directly with the ETF at NAV as well as on the market.

The expected result of the arbitrage activity is that the market price of the ETF’s shares moves back in line with the ETF’s NAV per share, and retail investors are able to buy ETF shares on an exchange at a price that is close to the ETF’s NAV per share.

As part of this arbitrage process, authorized participants are likely to hedge their intraday risk.

Volatility and Disruption

During periods of extraordinary volatility in the underlying ETF holdings, it may be difficult for authorized participants or market makers to confidently ascribe precise values to an ETF’s holdings, thereby making it more difficult to effectively hedge their positions.

Disruption in the share redemption or creation process is one situation in which the price of an exchange-traded product (ETP) can diverge significantly from the underlying value of its portfolio. Sometimes, an ETP may have wide bid-ask spreads or may trade at a large premium or discount to its value, depending on a product’s trading volume and other market factors.

Statutory Underwriter Status

ETFs register offerings of shares under the Securities Act of 1933 (the Securities Act) and list their shares for trading under the Securities Exchange Act of 1934 (the Exchange Act).

Depending on the facts and circumstances, authorized participants that purchase a creation unit and sell the shares may be deemed to be participants in a distribution, which could render them statutory underwriters and subject them to the prospectus delivery and liability provisions of the Securities Act.

Transaction Fees

An ETF may impose fees in connection with the purchase or redemption of creation units that are intended to defray operational processing and brokerage costs to prevent possible shareholder dilution (“transaction fees”).

Items E.3(d) and E.3(e) of Form N-CEN call for the average transaction fee charged to an authorized participant for transacting in the creation units.

Reporting Authorized Participants in Form N-CEN

Part E of Form N-CEN is titled Additional Questions for Exchange-Traded Funds and Exchange-Traded Managed Funds. Item E.2 of Part E is titled Authorized participants.

Central Registration Depository (CRD) is the securities industry online registration and licensing database. The Legal Entity Identifier (LEI) is a unique 20-character alphanumeric code that enables anyone, anywhere in the world, to access clear, unique identification data about a legal entity. RSSD ID is a unique identifier assigned to institutions by the Federal Reserve Board.

Item E.2 calls for the following information about each authorized participant of the fund: the full name; the SEC file number; the Central Registration Depository (CRD) number; the Legal Entity Identifier (LEI), if any, or if no LEI, the RSSD ID, if any; the dollar value of the fund shares the authorized participant purchased from the fund during the reporting period; and the dollar value of the fund shares the authorized participant redeemed during the reporting period.

Item E.2 also asks whether the fund required that an authorized participant post collateral to the fund or any of its designated service providers in connection with the purchase or redemption of fund shares during the reporting period.

Item E.3 of Part E is titled Creation units. Item E.3(a) calls for the number of fund shares required to form a creation unit as of the last business day of the reporting period.

Based on the dollar value paid for each creation unit purchased by authorized participants during the reporting period, Item E.3 calls for the average percentage of that value composed of cash, the standard deviation of the percentage of that value composed of cash, the average percentage of that value composed of non-cash assets and other positions exchanged on an in-kind basis, and the standard deviation of the percentage of that value composed of non-cash assets and other positions exchanged on an in-kind basis. Item E.3 calls for the same four items based on the dollar value paid for creation units redeemed by authorized participants during the reporting period.

For creation units purchased by authorized participants during the reporting period, Item E.3 calls for the average transaction fee charged to an authorized participant for transacting in the creation units, expressed as dollars per creation unit, if charged on that basis; dollars for one or more creation units purchased on the same day, if charged on that basis; or a percentage of the value of each creation unit, if charged on that basis. Item E.3 calls for the average transaction fee for creation units the consideration for which was fully or partially composed of cash, expressed as dollars per creation unit, if charged on that basis; dollars for one or more creation units purchased on the same day, if charged on that basis; or a percentage of the cash in each creation unit, if charged on that basis.

Item E.3 calls for the same two sets of average transaction fees for creation units redeemed by authorized participants during the reporting period.

The instruction to Item E.3 uses this definition: the term creation unit means a specified number of Exchange-Traded Fund or Exchange-Traded Managed Fund shares that the fund will issue to (or redeem from) an authorized participant in exchange for the deposit (or delivery) of specified securities, cash, and other assets or positions.

Other Provisions of Rule 6c-11 That Refer to Authorized Participants

Rule 6c-11(b)(4) addresses a redemption that includes a foreign investment. If an exchange-traded fund includes a foreign investment in its basket, and if a local market holiday, or series of consecutive holidays, or the extended delivery cycles for transferring foreign investments to redeeming authorized participants prevents timely delivery of the foreign investment in response to a redemption request, the exchange-traded fund is exempt, with respect to the delivery of the foreign investment, from the prohibition in section 22(e) of the Investment Company Act of 1940 (the Act) against postponing the date of satisfaction upon redemption for more than seven days after the tender of a redeemable security, if the exchange-traded fund delivers the foreign investment as soon as practicable, but in no event later than fifteen days after the tender of the exchange-traded fund shares.

Under Rule 6c-11(c)(3), an exchange-traded fund must adopt and implement written policies and procedures that govern the construction of baskets and the process that will be used for the acceptance of baskets. If the exchange-traded fund uses a custom basket, these written policies and procedures also must set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the exchange-traded fund and its shareholders, including the process for any revisions to, or deviations from, those parameters, and must specify the titles or roles of the employees of the exchange-traded fund’s investment adviser who are required to review each custom basket for compliance with those parameters.

Under Rule 6c-11(b)(3), a person who is an affiliated person of an exchange-traded fund, or who is an affiliated person of such a person, solely by reason of holding with the power to vote 5 percent or more of the exchange-traded fund’s shares, or holding with the power to vote 5 percent or more of any investment company that is an affiliated person of the exchange-traded fund, is exempt from sections 17(a)(1) and 17(a)(2) of the Act with regard to the deposit and receipt of baskets.

Under Rule 6c-11(a)(2), notwithstanding the definition of exchange-traded fund in paragraph (a)(1), an exchange-traded fund is not prohibited from selling, or redeeming, individual shares on the day of consummation of a reorganization, merger, conversion or liquidation, and is not limited to transactions with authorized participants under these circumstances.

Exchange-Traded Notes

While similar to the creation and redemption mechanism for other ETPs, exchange-traded notes (ETNs) don’t use authorized participants. Instead, an ETN issuer has primary control over ETN issuance and redemption, as this directly impacts the issuer’s balance sheet.

Exam Relevance

Candidates should check the current outline for their examination.

The Securities Industry Essentials (SIE) Exam content outline lists, in Section 2, Understanding Products and Their Risks, Topic 2.1.9, Exchange-traded Products (ETPs). Types of ETPs lists exchange-traded funds (ETFs) and exchange-traded notes (ETNs) beneath it. The knowledge bullets for that topic list alternative investments to mutual funds, fee considerations, and active vs. passive.

The Series 7 content outline lists, in Function 3, Section 3.2, Reviews and analyzes customers’ investment profiles and product options to determine that investment recommendations meet applicable standards, under Packaged products, the bullet Investment companies, exchange-traded funds (ETFs), unit investment trusts (UITs).

Common Misunderstandings

Retail investors create and redeem ETF shares directly with the ETF. Typically only authorized participants purchase and redeem shares directly from the ETF, and other investors, including retail investors, purchase and sell ETF shares in market transactions at market prices.

Authorized participants are the only firms that trade ETF shares. Market makers, proprietary trading firms, and hedge funds provide additional liquidity to the ETF market through their trading activity.

An authorized participant must be a broker-dealer. The definition in Rule 6c-11(a)(1) refers to a member or participant of a clearing agency registered with the Commission, and authorized participants typically are large broker-dealers.

An authorized participant always keeps the ETF shares it creates. After purchasing a creation unit, the authorized participant may hold the individual ETF shares, or sell some or all of them in secondary market transactions.

Authorized participants act only for themselves. An authorized participant may act as a principal for its own account, and authorized participants also may act as agent for others, such as market makers, proprietary trading firms, hedge funds or other institutional investors.

Creating and redeeming creation units carries no charge. An ETF may impose fees in connection with the purchase or redemption of creation units that are intended to defray operational processing and brokerage costs to prevent possible shareholder dilution.

An authorized participant is never treated as an underwriter. Depending on the facts and circumstances, authorized participants that purchase a creation unit and sell the shares may be deemed to be participants in a distribution, which could render them statutory underwriters.

Every exchange-traded product uses authorized participants. ETNs don’t use authorized participants. An ETN issuer has primary control over ETN issuance and redemption.

Key Points to Retain

An authorized participant is a member or participant of a clearing agency registered with the Commission that has a written agreement with the ETF or one of its service providers allowing it to place orders for the purchase and redemption of creation units. Authorized participants typically are large broker-dealers.

Typically only authorized participants purchase and redeem shares directly from the ETF, in large aggregations or blocks. Other investors purchase and sell ETF shares in market transactions at market prices.

To create, the authorized participant deposits a basket with the ETF and receives a creation unit of ETF shares. To redeem, the authorized participant delivers ETF shares to the fund and receives a pre-defined basket of individual securities, or the cash equivalent.

An authorized participant may act as a principal for its own account or as agent for others, and it may receive fees for processing creation units on their behalf.

Authorized participants can arbitrage a difference between the market price and the NAV per share, and the expected result is that the market price moves back in line with the NAV per share.

Authorized participants that purchase a creation unit and sell the shares may be deemed to be participants in a distribution, which could render them statutory underwriters.

Item E.2 of Form N-CEN calls for information about each authorized participant of the fund, and Item E.3 calls for the average transaction fees charged to authorized participants for creation units.

ETNs don’t use authorized participants.