Trading in ETF Basket Securities by an Authorized Participant

Counsel for an ETF sponsor retained Cornerstone Research to examine the potential manipulation of the NAV of certain fixed-income ETFs through trading in the market for the underlying bonds.

Cornerstone Research was retained by counsel for a large financial institution to assist with its internal investigation into whether the net asset value (NAV) of certain high-yield exchange-traded funds (ETFs) was manipulated through trading in the market for the underlying bonds.

We examined whether manipulative trading occurred in certain bonds in the delivery basket of an authorized participant (AP) such that the bond price was inflated close to 3:00 PM, when the fund’s NAV was calculated. This inflation would benefit the AP if the bond was included in the AP’s delivery basket in a higher proportion than its weight in the fund’s portfolio. However, fund shareholders would be damaged as the delivery basket would be overvalued, causing the fund to issue “too many” shares to the AP.

We analyzed bond trading data from FINRA, quotation data from Bloomberg, and “request for quotes” data from the AP to examine whether there was a pattern of trades at abnormally high prices close to 3:00 PM in bonds included in the AP’s delivery basket. We calculated the potential inflation in the bond price and the associated damages.

We presented our findings to the relevant parties, including the SEC and the ETF’s board.