A Primer on ETFs
Written by Wilfred Daye, Chief Executive Officer
Looking under the hood: CEO Wilfred Daye explains exchange-traded funds.
Jan 20, 2024Exchange-traded fund (ETF) shares offer the flexibility of intraday buying and selling on the exchange and can be created or redeemed at the end of the day, allowing the fund size to adjust based on end-investor demand. However, there are two key distinctions in how this process operates in an ETF compared to a traditional open-end mutual fund.
In an ETF, end-of-day primary trades are facilitated by a pre-approved group of institutional firms known as Authorized Participants (APs). These APs have entered into agreements with the ETF's distributor to manage the creation or redemption of shares.
In many ETFs, primary trades occur in-kind and do not involve direct securities purchases or sales by the ETF. APs present a basket of securities to the ETF (or receive a basket of securities from the ETF) in exchange for ETF shares. As aforementioned, current spot bitcoin ETFs are cash-based only, and require APs to buy and sell bitcoin for exchange into cash.
The Creation and Redemption Mechanism
The operational framework of ETFs involves a structured process of daily disclosure, creation, and redemption facilitated by APs, entities selected by the ETF sponsor or issuer based on their expertise in trading underlying securities. The creation and redemption process plays a pivotal role in maintaining liquidity and responding to excess buying or selling demand through the arbitrage mechanism. To qualify as an AP, an entity must be a registered broker-dealer, participate in the Depository Trust Company (DTC), and have a formal agreement with the issuer, known as the "Authorized Participant Agreement”, which outlines the following:
The procedures for creating and redeeming baskets,
The mechanism for transferring bitcoin to and from the bitcoin custodian through designated accounts,
A guideline for the delivery of bitcoin in connection with these processes, and
A comprehensive list of current APs is available through the Trustee or the Sponsor.
The ETF trust engages in continuous issuance and redemption of Baskets, occurring on days when national stock exchanges are open for regular trading.
On each business day, ETFs disclose their current holdings and eligible securities for creations or redemptions. In-kind transactions between APs and ETFs transpire through the exchange of identical or similar baskets of securities. The Trustee determines the daily amount of bitcoin required for each basket, emphasizing that no ETF shares are issued unless the corresponding amount of bitcoin has been allocated to the Trust's account by the bitcoin custodian.
In the case of a bitcoin ETF structured as a grantor trust, the physical asset is securely stored, usually in a custodian's facility. The trust then issues shares representing beneficial interests in its net assets. Investors receive grantor trust letters containing tax information, distinct from the conventional inclusion in their 1099 forms.
Working Mechanism of Spot Bitcoin ETF – Cash-based Only
Source: BlackRock and SEC Filing
The graphic above shows the operational sets of cash-based model for spot bitcoin ETF redemption as shown in BlackRock’s SEC filing. Noticeably, current model requires a cash custodian and a bitcoin custodian. SEC does not allow broker-dealers (BDs) to handle bitcoin directly, only the issuer and bitcoin custodian can. Here, we summarize the operational workflow of a typical cash redemption.
Market Maker-Broker Dealer (MM-BD) initiates a redemption order through the AP due to ETF dislocation from Net Asset Value (NAV) (Steps 1a-1b).
ETF Issuer approves the redemption order (Steps 2a-2b).
MM-BD acquires ETF shares via the Listing Exchange.
ETF Issuer directs the Bitcoin Custodian to transfer bitcoin from cold storage for sale.
ETF Issuer engages in a trade with MM-crypto to sell bitcoin for USD.
MM-crypto delivers cash to the Transfer Agent (DTC) (Steps 6a-6b).
Bitcoin Custodian transfers bitcoin to MM-crypto through a transfer via a crypto Prime Broker (Steps 7a-7c).
MM-BD delivers shares to the Transfer Agent through the AP (Steps 8a-8b).
ETF Issuer instructs the Cash Custodian to release cash to MM-crypto via the AP (Steps 9a-9c).
MM-crypto unwinds the short bitcoin position.
As shown above, steps 4-7 involve buy or sell of physical bitcoin into USD to meet cash-based redemption model. The "in-kind" model obviates these steps and would significantly reduce operational complexity. The cash-based model deprives investors the following benefits inherited in the "in-kind" model:
Lower Transaction Costs: The in-kind model typically incurs lower transaction costs compared to certain cash models.
Execution Risks Borne by Crypto Market Makers: In this model, the burden of execution risks is shouldered by crypto market makers rather than investors, contributing to a more secure investment environment.
Superior Resistance to Market Manipulation: The in-kind model exhibits enhanced resilience against market manipulation, providing a more robust safeguard for investors.
Removal of Need for Issuers to Finance or Pre-fund Sell Trades: By adopting the in-kind model, the necessity for issuers to finance or pre-fund sell trades is eliminated, streamlining the operational process.
Reduction in Risks of Operational Risk: The in-kind model reduces operational steps and mitigate operational risks.
Efficient Market Microstructure: Arbitrage and hedge are more efficient with physical creations. Self-clearing ETF MMs can facilitate efficient arbitrage in acting as agency APs for non-self-clearing ETF MMs with crypto affiliates.
Furthermore, the “in-kind” model is more tax efficiency for APs. When an AP redeems shares, the ETF issuer compensates the AP with assets directly from the underlying holdings of the ETF. This process avoids triggering a taxable event for the AP, as they are not selling the underlying assets. Consequently, there are no capital gains concerns for the AP until they decide to sell their actual shares. However, creation or redemption in cash introduces a taxable event, making cash-based ETFs less efficient for APs.
ETF Secondary Trading
The ETF-AP system offers advantages in shielding funds from trading costs. Unlike mutual funds, where the fund company incurs trading costs when investors contribute or withdraw money, ETFs delegate most buying and selling activities to APs, who cover associated costs and fees.
The secondary market liquidity of ETFs distinguishes them from traditional open-end mutual funds. ETF shares can be traded intraday on exchanges, providing an additional layer of liquidity for investors.
Secondary market trading volume in ETF shares often exceeds creation and redemption activity, offering incremental exchange liquidity beyond underlying assets. ETFs have demonstrated resilience during market stress, with ETF shares being as liquid as underlying portfolio assets. When confronted with an imbalance of buy or sell orders in the secondary market, MMs initiate new share creations and redemptions of existing shares in ETFs through APs.
Below, we highlight two unique risk factors associated with ETFs: AP disruption risk and redemption risk.
ETFs Face AP Disruption Risk
Large and diversified market ETFs typically attract a wide array of APs, whereas smaller and more narrowly defined funds may have a limited number of APs possessing specialized trading skills. It is essential to acknowledge the diversity and quantity of APs actively engaged with ETFs offered by various sponsors. The presence of additional APs, including those not currently active in a particular ETF, introduces a competitive dynamic. This competition becomes evident when an imbalance of ETF shares cannot be resolved through the secondary market.
Firms that act as MMs in a specific ETF may also function as APs for that ETF. MMs engage in acquiring long or short positions in ETF shares through secondary market trading, and they manage these inventories by either redeeming shares or creating new ETF shares as APs. Although these roles are distinct within the ecosystem, it is crucial to note that not all MMs necessarily assume the role of APs. APs, while having the capability to create or redeem shares of any product, exhibit diverse business models and strengths. Furthermore, not all APs choose to be active across all ETFs; they often concentrate their activities on ETFs where they possess expertise in the underlying asset class or securities. ETFs with high secondary market trading volumes tend to attract a greater number of APs compared to less liquid products.
In the event of a single AP withdrawing, alternative APs can step in to facilitate creations and redemptions of ETF shares. Significantly, if a substantial premium or discount exists, other APs are economically incentivized to intervene. For instance, if a sharp dislocation causes the ETF to trade below the value of its underlying securities, an AP may purchase the ETF and redeem the shares for securities worth more, thereby securing a profit. Conversely, if the ETF price surpasses the underlying basket value, the AP might engage in short selling the ETF and covering the short position by buying the underlying basket or an equivalent derivatives position.
However, if all APs withdraw simultaneously, the creation/redemption mechanism for adjusting ETF shares may experience a temporary freeze. This implies that the supply of ETF shares could be fixed in the short run, resembling the scenario of a Closed-End Fund (CEF). Nevertheless, the ETF share price, determined on the exchange based on supply and demand, could still exhibit a premium or discount to the Net Asset Value (NAV) of the underlying securities. Due to the economic incentive for APs to capitalize on arbitrage opportunities, any significant premium or discount would be swiftly arbitraged away.
ETFs Face Redemption Risk
This section explores the complex dynamics that govern the trading and redemption processes of ETFs, focusing on the disparity between the volume of ETF shares traded on exchanges and the total outstanding shares, and the role of securities lending and short selling in ETFs.
The number of shares of ETF) traded on exchanges through secondary market mechanisms differs from the total number of ETF shares outstanding. The trading volume of ETF shares does not necessarily correspond to the quantity of shares available for redemption through primary market activities. In ETFs, the shares transacted can be relatively large compared to the total shares outstanding. The in-kind mechanism employed by most ETFs mitigates redemption risk, eliminating the need for cash reserves to manage substantial redemptions. Instead, in the event of redemptions, ETF sponsors typically return the underlying basket of securities, in-kind, to the AP.
Like other equities, ETF shares may be lent to borrowers engaging in short selling. Short selling an ETF can lead to an apparent increase in the total number of shares traded. Despite the shares being sold and transferred to a different owner through the short seller, the lender of the shares still retains beneficial ownership. The securities lending market has established rules to clarify the retention of certain rights by the lender and the transfer of other rights with the lent security, preventing any duplication of ownership rights. While short sales contribute to exchange liquidity and may create an impression of a higher total number of shares in circulation than the outstanding shares, only the outstanding shares issued by the ETF are eligible for redemption. This is because ETFs release redemption proceeds only upon confirmation of the delivery of actual ETF shares earmarked for redemption. In cases where an ETF share owner has loaned their shares to a short seller, they temporarily lose the right to redeem until the shares are recalled from the borrower. Any redemption attempted by a party lacking possession of ETF shares for settlement (e.g., due to lending them to a short seller) will be nullified.
Conclusion
We delve into the operational intricacies of Exchange-Traded Funds (ETFs), emphasizing their unique features in contrast to traditional mutual funds. The utilization of APs for primary trades, the in-kind creation and redemption process, and the role of APs in maintaining liquidity are highlighted. The cash-based only model for spot bitcoin Spot represents a balanced compromised between regulatory development and institutional adoption. We expect that the “in-kind” will be accepted by the SEC in the future. Risks associated with AP disruption and redemption are acknowledged, with emphasis on the economic incentives for APs to mitigate such risks. We also discuss the dynamics of trading volume versus outstanding shares, underlining the in-kind mechanism's role in managing redemption risk.
