The Paradox of ETFs: Liquidity Transformation versus Index-Tracking

44 Pages Posted: 3 Mar 2021 Last revised: 9 Apr 2021

See all articles by Naz Koont

Naz Koont

Columbia University - Columbia Business School

Yiming Ma

Columbia University - Columbia Business School

Yao Zeng

University of Pennsylvania - The Wharton School

Date Written: November 15, 2020

Abstract

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

Koont, Naz and Ma, Yiming and Zeng, Yao, The Paradox of ETFs: Liquidity Transformation versus Index-Tracking (November 15, 2020). Available at SSRN: https://ssrn.com/abstract=3796474 or http://dx.doi.org/10.2139/ssrn.3796474

Naz Koont

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

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

Yiming Ma (Contact Author)

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Yao Zeng

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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