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It is my understanding that authorized participants are typically market makers. Is there a legal reason that prevents an ETF operator from allowing anyone to submit a basket? Or is it driven by operational cost or something else?

If it is operational cost, why can't the process be automated/cheap?
If it is a legal reason, will you please tell me where I can read more?

  • You claim to be a CFA as per your moniker and you don't know? – Dilip Sarwate Aug 17 '18 at 18:32
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    Correct, I believe it is better to be seen as ignorant for asking a question than to refrain from asking. – Charles Fox Aug 17 '18 at 19:22
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I suspect the reason is that it isn't currently feasible/worthwhile to fully automate, in advance, the exchange of securities by the ETF sponsor with an arbitrarily titled account at an arbitrary broker. (By contrast, similar automation does exist, by necessity, for exercise of options through OCC.) The ETF sponsor can more easily work out agreements with selected firms, prearrange the legal and logistical details, and then offer the actual transaction as a customized push-button for the APs.

Allowing all unrelated firms, affluent individuals, etc., to become self-appointed APs would complicate the IT and regulatory issues for the sponsor, for little benefit, because arbitrage competition among even a few large APs can usually keep the ETF tracking its index well.

  • Great, thank you @nanoman. I did not consider the similarity to open/close transactions with options. It sounds like it might be conceivable for an ETF provider to select a single electronic broker if it thought there was a benefit. – Charles Fox Aug 18 '18 at 4:47
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    @CharlesFox It looks like that can indeed happen -- Interactive Brokers offers its institutional clients the ability to act as an AP for certain ETFs. – nanoman Aug 18 '18 at 7:08
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APs can be large financial institutions (Bank America, Goldman Sachs, etc.) or more specialized market makers.

Prior to launching the ETF, the sponsor will determine which APs they will transact with. The sponsor may allow additional APs to sign up if others drop out or there is an increased need for more APs.

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    Thank you, but why can't/don't sponsors authorize everyone? Why is the designation required? – Charles Fox Aug 17 '18 at 18:17
  • Everyone as in retail people? Creation units can be 25,000 to 200,000 shares so that's a hefty amount of cash involved and excludes most people. I'd surmise that the need for additional creation units (or redeeming them) isn't an every day event. – Bob Baerker Aug 17 '18 at 18:44
  • Yes, I was wondering about retail. I agree that large creation units do rule out most people, which makes me wonder why the authorized participant designation is necessary. Isn't it redundant? – Charles Fox Aug 17 '18 at 19:21
  • I don't follow why your hung up on this. It's just a label/title for someone (individual or institution) who performs this function. Any business can designate who will perform certain functions for it. – Bob Baerker Aug 17 '18 at 20:57
  • @BobBaerker "isn't an every day event" -- an ETF's number of shares outstanding fluctuates all the time as the APs arbitrage demand for the ETF versus its components. It's unlikely an ETF could maintain tracking without this. – nanoman Aug 18 '18 at 1:11

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