While the data showed the big three APs handle a majority of fund flows, in reality, dozens of other firms may be moving assets with a registered AP’s help. The Vanguard Total Bond Market ETF (BND) is the largest U.S. fixed-income ETF with around $103 billion in assets, yet the data suggest just three APs handled 98% of its flows. Vanguard declined to confirm whether some APs act as prime brokers for BND, but said “many market makers in Vanguard ETFs do not serve as Authorized Participants.”
Even though bigger APs continue to dominate, nontraditional players are making strides in the arena. Firms like Virtu Financial Inc., Citadel Securities LLC, Hudson River Trading and Jane Street have made significant gains in AP market share in recent years, the data show, including by stepping in as liquidity providers during the Covid crash.
Several of these firms have always had a strong presence market-making and trading ETFs, but they frequently manage positions through other channels such as borrowing or lending securities. They use creation and redemption when the costs make sense.
Representatives for Virtu and Citadel declined to comment. Hudson River and Jane Street didn’t respond to emails requesting comment.
Remembering how ETFs fared during the throes of the pandemic in 2020 may also alleviate some worries about mispricing. When underlying fixed-income markets froze, ETF shares kept trading—providing vehicles of price discovery and a mechanism for transferring bond risk despite the seizure.
Nevertheless, these caveats don’t dispel all concentration concerns. Sikorskaya, formerly of Deutsche Bank AG’s ETF arm, and co-author Evgenii Gorbatikov, a London Business School PhD, argue even the largest banks can face regulatory constraints or liquidity challenges at a time of turmoil. Under regulations introduced in the wake of the financial crisis, big banks haven’t been able to take much risk, raising the chances they could scale down their AP role when their services are needed most.
The researchers studied when the prices of equity ETFs diverged from the value of their assets and related it to each product’s AP connections. When they compared the average mispricing of the third of funds with the fewest APs against the third with the most during the Covid selloff, they recorded a more than 50 basis-point bigger deviation in the former.
The AP-concentration effect was evident even when controlling for general turnover or liquidity of a fund, meaning the mispricing wasn’t bigger because of other characteristics of the ETFs. The duo expect dislocations of “much larger magnitudes” for fixed-income or commodity ETFs because these are less liquid and more concentrated parts of the market, Sikorskaya said.
Bloomberg’s analysis showed that commodity ETFs display some of the highest levels of AP concentration. Four firms handled almost all the flows in and out of these products during the third quarter of 2022, with Virtu edging in to join the three banks. The narrow participation is likely a reflection of the challenges of working in an asset class prone to heightened volatility and liquidity mismatches between ETFs and their physical holdings. Futures-based trading adds complexity.
Overall, more than 280 ETFs recorded just a single active AP in the third quarter of 2022. For the most part, these are newer funds with extremely low trading activity— there’s not much need for creation and redemption if there are no flows. But the largest was the $2 billion JPMorgan BetaBuilders U.S. Aggregate Bond ETF (BBAG), underscoring that even established products can be heavily dependent on as few as just one name.
“If something does happen again, are other APs going to step in?” said Bloomberg Intelligence ETF Analyst Athanasios Psarofagis, referring to the next market crisis. “You know, we like to think that they will, and hopefully that they will. But I don’t know if we have enough data to say, ‘Oh yeah, this will definitely happen.’”
Methodology:
Bloomberg News analyzed bulk data of N-CEN filings released by the Securities and Exchange Commission, updated on Sept. 30, 2023. This type of regulatory filing, on which details of ETF funds are disclosed, is submitted annually by registered investment companies in the U.S.
As fiscal calendars vary across different ETF operators, this analysis converted the annual data into quarterly to better display trends over time.
Financial firms may have numerous affiliates working as separately reported authorized-participant entities. They have been matched back to their parent entity so that the activity levels of the groups can be measured.
When filings are amended, the most recent versions are included in the analysis.
When discussing AP activities, this analysis combined the ETF share creation and redemption flows to track the combined volumes. An AP that has handled at least $1 worth of transactions is considered an active AP for that ETF during the fiscal year. The investment strategy and AUM details of ETFs were sourced from data compiled by Bloomberg.
This article was provided by Bloomberg News.