By Richard Keary and Bibb Strench
The create-redeem process is the key reason why the exchange-traded fund (“ETF”) is a viable investment vehicle and one of the fastest growing products in financial history. Arguably, the mechanics of and the ecosystem that has built up around the creation and redemption process for ETFs, has made it the most superior pooled product to date including a far more efficient way as compared to mutual funds and hedge funds for investors to gain exposure to a group of securities. Without this mechanism, the trading price of the ETF share would diverge too far from the actual net asset value of that share (the value of the basket of securities that the ETF holds divided by the number of its outstanding shares). Without the marketplace having a high degree of confidence of the existence of a robust create-redeem process, ETF shares would trade at such large bid-ask spreads that the product would be virtually uninvestable.
Fortunately for investors, ETF issuers, their service providers and regulators, the create-redeem process has worked exceptionally well since the ETFs launched almost 30 years ago. Regulators, primarily the Securities and Exchange Commission (“SEC”), heavily influenced the structure of the ETF when allowing the first ETF to be offered to investors and trade on the national securities exchanges. Recently, the SEC has been taking a fresh look at the ETF create-redeem process as well as block trades, the key component of that process.
After discussing the core role of the create-redeem process, we highlight the fact that the SEC lightly regulates the process but it has concerns that the ETF industry should be mindful of to avoid giving the SEC an invitation to more directly regulate ETF creations and redemptions.
Critical Role of the Creation-Redemption Process
The basic building block of the first ETF in the early 1990s was a basket of securities that had to be assembled and delivered to the ETF issuer in exchange for its shares. Basket of securities such as baskets made up the individual companies in the S&P 500 index had been trading for about a decade. The process of large financial institutions trading securities in blocks was adapted to the ETF. The ETF issues and redeems shares that have been aggregated into blocks of 5000 shares or multiples thereof (Creation Units) to APs who have entered into agreements with the fund’s distributor. Highly sophisticated financial institutions, most notably the AP on one side of the transaction, and the ETF’s distributor on the other side of the transaction, hammered out a contract governing this commercial process, which is called the AP agreement. The preamble of such a typical AP agreement illustrates the operational complexities involved in this process:
This Agreement is intended to set forth certain premises and the procedures by which the Participant may create and/or redeem Creation Units through the Federal Reserve/Treasury Automated Debt Entry System maintained at the Federal Reserve Bank of New York and the Continuous Net Settlement (CNS) clearing processes of NSCC (as such processes have been enhanced to effect purchases and redemptions of Creation Units) or, outside of the CNS Clearing Process, the manual process of The Depository Trust Company.
In addition to the mechnical role the create-redeem process in terms of assembling and de-assembling baskets of securities for the ETF, it serves other vital functions such as being the sole mechanism by which the ETF may grow and the ETF issuers sole direct links to APs and indirectly to market makers that function as liquidity providers to the ETF. By SEC rule, all orders for ETF shares must be placed by APs.
APs not only serve as the ETF’s conduit to investors in this role, as part of the process, they often trade in the underlying securities that the ETF holds and such trading provides additional liquidity to the ETF’s portfolio as well as the ETF’s own shares whose liquidity is tied to the liquidity of the underlying portfolio. The bid/ask spread of a given ETF, which is one form of measurement of the ETF’s shares, typically narrows as the underlying securities become more liquid. A discussion paper by the Ireland Central Bank observed: “A key feature of ETFs is that the primary dealing mechanism facilitates secondary market liquidity.” Ireland, Central Bank, “Exchange-Traded Funds – Discussion Paper” (2017) https://www.centralbank.ie/docs/default-source/publications/discussion-papers/discussion-paper-6/discussion-paper-6—exchange-traded-funds.pdf.
ETF issuers are highly dependent on APs, which while contractually linked to the ETF issuers, voluntarily participate in the process. An AP owes no “fiduciary duty to the ETF (as their interests are purely commercial ones) and so the ETF is exposed to the risk that these interests, particularly in a stressed environment, will outweigh the commercial obligation … and commercial relationship as the (de facto) sole conduit for investor access to the ETF.” Id. at 17. Therefore, if the ETF has “structuring” complexities it will not be an attractive investment proposition for an AP. Id. at 46.
Functioning of the Creation-Redemption Process
Both the ETF industry and the SEC recognized that there may be extraordinary circumstances necessitating suspending creations and redemptions. For example, a comment letter from an ETF complex noted that suspensions of creations are rare, but an ETF could suspend creations when it is unable to increase its exposure to underlying assets, such as when a non-U.S. market suspends capital inflows. Exchange Traded Funds, Investment Company Act Rel. No. 33646 (Sept. 25, 2019). The SEC also recognized in the release adopting Rule 6c-11 its belief “that an ETF generally may suspend the issuance of creation units only for a limited time and only due to extraordinary circumstances, such as when the markets on which the ETF’s portfolio holdings are traded are closed for a limited period of time.” Id.
This leads to the question of whether there should be any concern about advisers to ETFs suspending creations and redemptions during normal operations or market conditions. AP agreements and language in the ETF’s Statement of Additional Information provide the ETF ample rights to suspend creation and redemption orders, and, for good reasons. They are designed to protect the ETF and its shareholders; for example, an ETF may reject a purchase order if the AP is not able to show it has good title to the portfolio securities it is delivering. The ability of an ETF adviser to suspend creates because of supply/liquidity issues is a necessary trigger for an adviser to have to protect the integrity of the ETF when the underlying market’s pricing mechanism has been dislocated. So, there is an inherent division between the ETF structure and market structure. The only way for an ETF’s adviser to protect shareholders (given that they do not control the underlying markets) is to be able to cancel creates/redeems when there is a pricing mechanism dislocation or liquidity issues. Direct SEC regulation of the create-redeem process potentially could put ETF advisers and ETF shareholders at risk by limiting their means to address market disruptions.
Intuitively, we believe that the ETF issuer has little or no incentive to exercise its contractual right to disrupt the creation-redemption process through purchase and redemption suspensions, absent an extraordinary circumstance or if the AP order is defective. First, an ETF issuer has little financial incentive to turn away new assets. Second, an ETF would not want to gain a reputation for suspending creation orders because it likely would have to widen bid/ask spreads to attract APs because of the perceived risk that is order might be rejected after it assembled the basket.
We reached out to several participants from companies actively engaged in different aspects of the create-redemption to ascertain how common suspensions are and for what reasons, as well as eliciting their views on well the creation-redemption process is working.
The SEC clearly recognizes the create-redeem process is the lynchpin of the ETF. In fact, the SEC in Rule 6c-11 under the Investment Company Act of 1940, as amended (the “1940 Act”), defined an ETF to be a fund “that issues (and redeems) creation units to (and from) authorized participants in exchange for a basket and a cash balancing amount if any.” It is noteworthy that while the SEC included the create-redeem process in the ETF’s definition, neither Rule 6c-11 nor the exemptive orders that preceded the Rule directly regulate the process. It remains a commercial process between private participants that is governed by contract. In simple terms, the SEC by rule requires ETFs to have plumbing installed and operated by regulated entities, but its rule does not regulate the plumbing itself. Authorized Participants (“APs”), unfettered by regulatory constraints, have done yeoman’s work with ETF custodians and distributors to deliver a highly efficient create-redeem process that is largely under the floorboards of the wildly successful ETF industry.
Unregulated processes should never be taken for granted even if there is no reason or event suggesting that they should be regulated. Section 22(d) and Rule 22c-1 provide the SEC with the ability to directly regulate the create-redeem process as ETFs in order to sell their shares on an exchange need exemptions from these and other regulations to operate. The SEC in the release adopting Rule 6c-11 reminded the ETF industry of its statutory authority to regulate in this area, noting its concern were an ETF to suspend creation or redemption orders for an extended period of time. Certainly, the SEC’s interest in the create-redeem process is understandable, as a breakdown in this process would lead to a failure of the arbitrage process resulting in untradeable ETF share price spreads. Importantly, however, this concern must be weighed against an arguably even greater and more practical concern: regulatory intrusion adding friction to the create-redeem process that damages the arbitrage process by making it more costly and risky for APs, causing them to lose their appetite to voluntarily participate in that process.
When it adopted Rule 6c-11, the SEC stated that the Rule’s “conditions generally are consistent with the conditions in our exemptive orders, which we believe have effectively accommodated the unique structural and operational features of ETFs while maintaining appropriate protections for ETF investors.” Id. There is no better illustration of the delicacy of the balance of industry and regulatory interests than the create-redeem process. The SEC observed that an “orderly creation unit issuance and redemption process is essential to a properly functioning arbitrage mechanism.” The SEC resisted imposing conditions in Rule 6c-11 that might interfere with this process. For example, it did not act on one commenter’s recommendation that the Rule require an ETF to have a minimum number of APs. In addition, it chose not to regulate the size of a creation unit: “Rule 6c-11 will not mandate a maximum or minimum creation unit size or otherwise place requirements on creation unit size.” Id.
One possible reason for choosing not to interfere with the create-redeem process was the SEC’s awareness that both the participants in that process – namely, the AP, custodian and distributor – are highly regulated entities. Furthermore, the create-redeem process starts with an AP’s trading desk delivering the basket securities and how they obtain those securities is under the purview of FINRA and the applicable stock exchange.
One facet of the creation-redemption process that the SEC did address was the ETF’s ability to suspend creation and redemption orders. The SEC stated that “we believe that an ETF generally may suspend the issuance of creation units only for a limited time and only due to extraordinary circumstances, such as when the markets on which the ETF’s portfolio holdings are traded are closed for a limited period of time.” It cautioned that “[i]f a suspension of creations impairs the arbitrage mechanism, it could lead to significant deviations between what retail investors pay (or receive) in the secondary market and the ETF’s approximate NAV.” It reminded the ETF industry that “the expected close tie between an ETF’s market price and NAV per share provides a basis for our relief from section 22(d) and rule 22c-1 under rule 6c-11 (as well as our prior exemptive orders).” Unjustified suspensions in the create-redeem process “would run counter to the basis for relief from section 22(d) and rule 22c-1 and therefore would be inconsistent with rule 6c-11.”
Notably, the SEC in the releases proposing and adopting Rule 6c-11 did not provide the source of its concern that an ETF might suspend creations or redemptions in ordinary times. In the proposing release, it posited: “Should we consider including provisions in rule 6c-11 that would permit ETFs to suspend creations or redemptions in particular circumstances?” Ultimately, the SEC decided not to add any such provisions or any other requirements impacting the create-redeem process. In fact, the SEC generally stated that the summary statistics presented thus far in this section suggest that the arbitrage mechanism generally functions effectively during normal market conditions. Three years later, however, the SEC staff in less direct ways has sought assurances that ETF issuers will not suspend creation and redemption orders absent extraordinary circumstances.
Investors in ETFs and investment advisers who sponsor and manage ETFs should understand the creation-redemption process, as it is critical to the ETF having tight trading spreads and being an attractive product. The industry as a whole should not take the essentially regulatory free workings of the redeem-process for granted, especially now that it has been reported that the SEC is looking at key aspects of it. Awareness of the create-redeem process, publicity about how well it has functioned to benefit millions of ETF investors and preparedness to ward off unnecessary and potentially harmful regulatory interference should be on the agenda of all ETF industry participants.