Can ETFs Increase Market Fragility? Effect of Information Linkages in ETF Markets
52 Pages Posted: 4 Mar 2016 Last revised: 3 Sep 2017
Date Written: August 25, 2017
We show how inter-market information linkages in ETFs can exacerbate market instability and herding. When underlying assets are hard-to-trade, informed trading may take place in the ETF, giving underlying market makers an incentive to learn from the ETF price. We demonstrate that this learning is imperfect: market makers pick up information unrelated to asset value along with pertinent information. This leads to propagation of shocks unrelated to fundamentals and causes market instability. Further, if market makers cannot instantaneously synchronize prices, inter-market learning can aggravate herding, where speculators across markets trade similarly, unhinged from fundamentals.
Keywords: ETF, Market stability, Learning, Market fragility, Herding, Market microstructure
JEL Classification: G14, D47, D82
Suggested Citation: Suggested Citation