The Paradox of ETFs: Liquidity Transformation versus Index-Tracking
44 Pages Posted: 3 Mar 2021 Last revised: 28 Mar 2022
Date Written: November 15, 2020
Index-tracking fixed-income ETFs have experienced an explosive growth spurt to reach $1 trillion in 2020. However, they suffered significant disruptions during the Covid-19 crisis. We show that bank balance sheet constraints were likely a contributing factor to these disruptions because bond ETF’s liquidity transformation crucially relies on arbitrage by authorized participants (APs), which are mostly dealer banks. We identify a key tension between liquidity transformation and index-tracking, two key functions performed by bond ETFs, and show that the constraints at dealer banks further exacerbate this tension. We find that increases in bank balance sheet costs, e.g., due to regulation, spill over to reduce both the liquidity transformation and index-tracking capacity of bond ETFs. Our results imply that the efficiency and stability of bond ETFs are contingent on that of the banking sector.
Keywords: ETFs, COVID-19, Liquidity Transformation, Tracking Error, Balance Sheet Costs
JEL Classification: G23, G28, G11
Suggested Citation: Suggested Citation