Operational Shorting and ETF Liquidity Provision

89 Pages Posted: 3 May 2017 Last revised: 4 Aug 2022

See all articles by Richard B. Evans

Richard B. Evans

University of Virginia - Darden School of Business

Rabih Moussawi

Villanova University - Department of Finance; University of Pennsylvania

Michael S. Pagano

Villanova University - Villanova School of Business

John Sedunov

Villanova University - Department of Finance

Date Written: June 30, 2022

Abstract

Due to a regulatory exemption, ETF market makers can satisfy excess demand in secondary markets by selling ETF shares that have not yet been created. While this ability to “operationally short” is not unique to ETFs, it plays a more prominent role in ETF liquidity provision, and results in elevated ETF failures-to-deliver. We propose a novel measure for “operational shorting” and show it is associated with improved liquidity and greater price efficiency in the ETF underlying securities. Higher retail trading activity and short-term return reversals are also consistent with liquidity-supplying motives rather than informed trading. Consequently, delayed ETF creation to cover operational shorts is found to be a valuable option in the presence of retail trading and liquidity mismatches between the ETF and its underlying securities.

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

JEL Classification: G1, G12, G14, G23

Suggested Citation

Evans, Richard B. and Moussawi, Rabih and Pagano, Michael S. and Sedunov, John, Operational Shorting and ETF Liquidity Provision (June 30, 2022). Darden Business School Working Paper No. 2961954, 2019 Academic Research Colloquium for Financial Planning and Related Disciplines, Available at SSRN: https://ssrn.com/abstract=2961954 or http://dx.doi.org/10.2139/ssrn.2961954

Richard B. Evans

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4030 (Phone)
434-243-7680 (Fax)

HOME PAGE: http://faculty.darden.virginia.edu/evansr/

Rabih Moussawi (Contact Author)

Villanova University - Department of Finance ( email )

800 E Lancaster Ave
Bartley Hall, 2051
Villanova, PA 19085
United States

HOME PAGE: http://www.homepage.villanova.edu/rabih.moussawi

University of Pennsylvania ( email )

3733 Spruce Street
216 Vance Hall
Philadelphia, PA 19104-6301
United States

HOME PAGE: http://www.rabihmoussawi.com/

Michael S. Pagano

Villanova University - Villanova School of Business ( email )

800 Lancaster Avenue
Villanova, PA 19085-1678
United States
(610) 519-4389 (Phone)

HOME PAGE: http://www90.homepage.villanova.edu/michael.pagano

John Sedunov

Villanova University - Department of Finance ( email )

800 Lancaster Ave.
Villanova, PA 19085
United States
610-519-4374 (Phone)

HOME PAGE: http://homepage.villanova.edu/john.sedunov/

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