Operational Shorting and ETF Liquidity Provision

Abstract

ETF market makers can satisfy excess demand in secondary markets by selling shares that are not yet created. While this ability to "operationally short" is not unique to ETFs, it plays a central role in ETF liquidity provision. We propose and validate a novel "operational shorting" measure. In addition to constituting a majority of ETF short interest, it is associated with higher retail trading activity and short-term return reversals, consistent with liquidity-supplying motives. Accounting for operational shorting is important in examining ETF returns, mispricing, and the asset pricing implications of ETF trading on underlying securities.

Keywords: Exchange-Traded Funds, Short selling, Failure to Deliver, Authorized Participants, Market Making, Liquidity, Retail Trading

JEL Classification: G1, G12, G14, G23