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Can ETFs Increase Market Fragility? Effect of Information Linkages in ETF Markets

52 Pages Posted: 4 Mar 2016 Last revised: 3 Sep 2017

Ayan Bhattacharya

Baruch College, The City University of New York

Maureen O'Hara

Cornell University - Samuel Curtis Johnson Graduate School of Management

Date Written: August 25, 2017

Abstract

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

Bhattacharya, Ayan and O'Hara, Maureen, Can ETFs Increase Market Fragility? Effect of Information Linkages in ETF Markets (August 25, 2017). Available at SSRN: https://ssrn.com/abstract=2740699

Ayan Bhattacharya (Contact Author)

Baruch College, The City University of New York ( email )

New York, NY 10010
United States

Maureen O'Hara

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States
607-255-3645 (Phone)
607-255-5993 (Fax)

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