Almost All of the $8 Trillion ETF Market Depends on a Few Key Firms

In the last five years, the assets in the US ETF market have more than doubled, witnessing the launch of over 1,000 new funds and an increase in annual trading volumes by around $11 trillion. However, within this rapid expansion, one crucial aspect has not seen a corresponding increase – the number of firms overseeing the flow of cash in and out of these ETFs.

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Authorized Participants (APs), a category of broker-dealers critical for the efficient functioning of every exchange-traded fund in North America, have seen minimal growth in numbers despite the industry's explosive expansion. In fact, the most active APs have strengthened their market share, resulting in a notable concentration within the $8 trillion ETF arena.

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A Bloomberg News analysis of filings for over 3,400 funds revealed that, despite the remarkable growth in the industry, more than half of all US ETF flows are managed by just three firms. For the majority of funds, over 90% of all money entering or exiting passes through three APs or fewer. In the latest quarter data available, hundreds of ETFs reported having only one active AP, highlighting their dependence on a single firm for cash movement.

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Research indicates that funds with fewer active APs are susceptible to greater mispricing in stress scenarios. Mispricing, where an ETF trades at a premium or discount to the value of its underlying assets, poses additional risks and potential higher costs for investors. It also undermines the reliable functioning of ETFs, which are considered one of Wall Street's most popular investment vehicles.

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The concentration of activity among just a few APs is a concern, as it can exacerbate mispricing during market turbulence, affecting investors seeking to rebalance or move to safer assets. While this mispricing might not be immediately apparent to most retail traders, it can impact the low-cost and efficient attributes that make ETFs attractive, particularly during market downturns.

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Authorized Participants typically correct price dislocations by either providing the ETF with more assets in exchange for newly created shares or buying existing shares in the market and redeeming them for assets from the fund. The concentration effect observed in the ETF market has been consistent even when accounting for general turnover or liquidity of a fund.

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The analysis also highlighted that commodity ETFs exhibit high levels of AP concentration, with four firms handling almost all the flows in and out of these products during the third quarter of 2022. This concentration is likely due to the challenges posed by the heightened volatility and liquidity mismatches in commodity ETFs compared to their physical holdings.

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More than 280 ETFs recorded just a single active AP in the third quarter of 2022, with the $2 billion JPMorgan BetaBuilders U.S. Aggregate Bond ETF (BBAG) among them, emphasizing that even established products can be heavily dependent on a minimal number of APs. This raises concerns about the ability of other APs to step in during the next market crisis, challenging the assumption that sufficient data supports this expectation.