This article was originally published on ETFTrends.com.
Just like the animal kingdom, the world of exchange-traded funds (ETFs) has its own living and breathing components that comprise the ETF ecosystem. Little do investors know that they’re all part of an even bigger map of the ETF ecosystem within an even bigger capital markets universe.
Encountering the various roles and knowing what those roles perform, such as data vendors, trustees, sub-advisors, and execution venues can be daunting–it can be akin to an animal lover getting parachuted into the middle of a zoo without a map–where does he or she start? Fortunately, ETF Trends in conjunction with ARRO Financial Communications created an ETF Ecosystem map that outlines the participants in the ETF ecosystem, as well as how they interact with one another.
Creation and Redemption
Every story begins with an origin and for ETFs, it all begins with the issuer, but there are other specific roles that all contribute to the creation/redemption aspect of the ETF ecosystem:
1. The ETF issuer communicates the fund’s market trades as well as details of the creation/redemption basket to the Custodian, who in turn provides safekeeping of the assets, as well as providing the ETF Issuer with an aggregate snapshot of the portfolio.
2. The ETF Issuer and Accounting/Custody work together to process and settle creation/redemption activity when there are orders.
3. When a creation or redemption order is processed, Accounting/Custody processes the underlying basket and the transfer agent processes the ETF shares.
4. In some operating models, the Authorized Participant places orders on the Primary Market with the Transfer Agent instead of directly with the Distributor.
5. Authorized Participants may buy or sell excess shares to the market through market participants. Market Makers may engage Authorized Participants to facilitate creations or redemptions.
6. Market Makers provide ETF liquidity by posting double-sided quotes on the national Stock Exchanges.
7. Brokers who wish to buy or sell retail quantities of ETF shares will facilitate these transactions on the Secondary Market through one of the national Exchanges.
8. Investors who wish to invest in ETFs will engage with a Broker, who buys or sells shares on their behalf.
9. Large Institutional investors may buy or sell ETF shares on the Secondary Market through alternative trading venues such as OTC (Over-the-Counter) and Dark Pools.
10. When a creation or redemption order is processed, the Medallion Distributor approves the order and provides final order details to Accounting/Custody.
11. The Medallion Distributor provides the Transfer Agent with creation/redemption activity for record keeping, and the Transfer Agent maintains this data for the use of the Medallion Distributor in shareholder communications.
12. Authorized Participants initiate creation and redemption activity on the Primary Market through Medallion Distributor systems, and the Medallion Distributor provides confirmations to Authorized Participants.
Regulation and Oversight
In order to ensure that the ETF ecosystem is running smoothly, regulatory bodies, such as the Securities and Exchange Commission (SEC), U.S. Commodity Futures Trading Commission (CFTC) and Financial Industry Regulatory Authority (FINRA), as well as parties like legal and compliance, provide the necessary oversight.
13. ETF Issuers operate under various rules and regulations including the SEC for asset management activities, FINRA for sales activities, and the CFTC when certain derivatives are involved.
14. The Investment Management division of the SEC monitors the Investment Advisor to ensure compliance with multiple federal regulations.
15. The NSCC (National Securities Clearing Corporation) is regulated by the SEC.
16. The Trading and Markets Division of the SEC monitors and works alongside Execution Venues to ensure efficient, transparent markets, as well as overall capital market integrity.
17. FINRA regulates member brokerage firms and exchanges.
18. FINRA monitors Brokers to ensure federal regulations are being followed. It also seeks to protect Investors from unscrupulous sales tactics.
19. Compliance monitors the ETF issuer and funds for compliance with regulations, policies, and procedures.
20. The Trustees monitor vendors and the general management of the trust to ensure shareholders’ rights and interests are being protected.
21. The Legal team assists the ETF Issuer with contracts and provides general counsel. It also sets the agenda for regular and special meetings of Trustees.
Distribution and Record-Keeping
Lastly, the ETFs make their way to the capital markets and as they are bought or sold, the necessary parties keep adequate records for distribution to the proper channels.
22. The Index Provider transmits daily index constituents to the ETF for the purpose of tracking the portfolio.
23. Data Vendors communicate various data points such as securities pricing, corporate action information, and website informatics to the ETF Issuer and its service providers.
24. The Sales Distribution team of an ETF issuer is usually in-house, but can be outsourced to a 3rd party.
25. The Sales Distribution team works to sell the ETF to Investors.
26. Marketing and PR sets messaging strategy as well as methods of communicating the ETF Issuer’s products to investors.
27. Marketing and PR communicates key information about the ETF to Investors by shaping branding, educational content, and messaging, as well as arranging media opportunities and appearances.
28. The investment Advisor monitors and manages the day-to-day operations of the ETF and its other service providers.
29. A Sub-advisor, if engaged, manages all or part of the investment portfolio of the ETF.
30. A Sub-advisor may be engaged on behalf of the primary investment advisor to manage some, or all, of the portfolio’s assets.
31. The Securities Lending Agent acts as agent of the Fund to manage the lending of portfolio securities. This service generally does not start until the fund has some scale.
32. The Custodian and Securities Lending Agent work in tendem to facilitate the borrowing of securities with proper record-keeping.
33. The Custodian transmits creation/redemption baskets nightly to the NSCC (National Securities Clearing Corporation) who then disseminates it to all member firms including back to the custodian.
34. The NSCC (National Securities Clearing Corporation) transmits ETF constituents to the IOPV (Indicative Optimized Portfolio Value) calculation agent each morning to generate estimated intra-day share price.
35. The NSCC (National Securities Clearing Corporation) transmits official creation/redemption basket to Exchanges for public dissemination.
For more baseline knowledge regarding ETFs, visit the ETF Education category.