Exchange-Traded Funds and Transparency in OTC Markets

Abstract

This paper explores a new channel through which exchange-traded funds (ETFs) can affect underlying asset prices. In over-the-counter markets, daily disclosure of ETF portfolio holdings increases pre-trade price transparency and thereby retail investors' bargaining power. I show that ETF-held municipal bonds have significantly smaller price dispersion than observationally similar non-ETF-held bonds. This effect cannot be explained by selection or ETFs' own trading activity. Conversely, ETF disclosure quality is associated with smaller bond price dispersion by up to 27 basis points. In the primary market, when municipalities have outstanding ETF-held bonds, their new issues have lower yields and smaller price dispersion.

Keywords: exchange-traded funds, market transparency, municipal bonds, price dispersion, OTC markets

JEL Classification: G12, G14, G23