DEFINITION of Authorized Participant
Authorized participants (AP) are one of the major parties at the center of the creation and redemption process for exchange-traded funds (ETF). They provide a large portion of liquidity in the ETF market by obtaining the underlying assets required to create a fund. When there is a shortage of shares in the market, the authorized participant creates more. Conversely, the authorized participant will reduce shares in circulation when supply falls short or demand. This can be done with the creation and redemption mechanism that keeps share prices aligned with its underlying net asset value (NAV).
BREAKING DOWN Authorized Participant
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 in the same weight 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 a greater number of authorized participants. This also differs between various types of funds. Equities, on average, have more participants than bonds perhaps due to greater trading volume.
Traditionally, authorized participants are large banks like Bank of America (BAC), JPMorgan Chase (JPM), Goldman Sachs (GS), and Morgan Stanley (MS), among others. 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 or service fees collected from clients yearning to execute primary trades.
In the end, both parties benefit from working together. The sponsor receives help in creating the fund while the participant gets a block of shares to resell for a profit. This process also works in reverse. Authorized participants receive the same value of the underlying security in the fund after selling shares.
Competition between Authorized Participants
Multiple authorized participants help improve the liquidity of a particular ETF. The threat of 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, other ones will see the product as a profitable opportunity and offer the creation/redemption technology. At the same time, the impacted authorized participant has the option to address any internal issues and resume primary market activities.