The Provision of Liquidity in ETFs: Theory and Evidence from European Markets

39 Pages Posted: 8 Sep 2016 Last revised: 10 Sep 2016

See all articles by Anna Calamia

Anna Calamia

University of Toulouse - Toulouse Business School

Laurent Deville

EDHEC Business School

Fabrice Riva

Université Paris-Dauphine, PSL Research University

Date Written: August 1, 2016

Abstract

ETF markets generally provide high levels of liquidity but occasionally break down under turbulent conditions. We show that this seemingly ambivalent behavior can optimally arise in an inventory model of market making that explicitly accounts for the ETF specific dual trading structure. Our model predicts that ETF spreads are increasing in market makers' risk aversion, underlying index volatility and benchmark stock basket illiquidity. Consistent with our model, we find that spreads on European equity ETF markets are determined by inventory risk-related variables. However, the benchmark stock basket’s liquidity matters only when market conditions do not allow for efficient inventory management.

Keywords: Exchange Traded Funds, market design, bid-ask spreads, liquidity provision, inventory management

JEL Classification: G10, G20

Suggested Citation

Calamia, Anna and Deville, Laurent and Riva, Fabrice, The Provision of Liquidity in ETFs: Theory and Evidence from European Markets (August 1, 2016). Available at SSRN: https://ssrn.com/abstract=2835907 or http://dx.doi.org/10.2139/ssrn.2835907

Anna Calamia

University of Toulouse - Toulouse Business School ( email )

20, bd Lascrosses
BP 7010
Toulouse, 31068
France

Laurent Deville (Contact Author)

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Fabrice Riva

Université Paris-Dauphine, PSL Research University ( email )

Place du Maréchal de Tassigny
Paris, Cedex 16 75775
France

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