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

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