Liquidity provision in ETF markets: The basket and beyond

Anna Calamia, Laurent Deville and Fabrice Riva

Finance, 2019, vol. 40, issue 1, 53-85

Abstract: We provide a theory and empirical evidence showing that the liquidity (quoted spread) of an ETF is strongly determined by inventory-risk related variables. We consider a risk averse market maker who optimally chooses to either manage her ETF position through trading, or resort to the ETF creation/redemption mechanism to exchange her residual inventory for the underlying basket. The trade-off between the ETF price concession and the cost of trading the basket is key in explaining liquidity provision in ETFs. Using data on European equity ETFs, we provide supporting evidence that ETF spreads depend on the risks and costs of inventory management. We also find that the ETF liquidity is linked with the basket liquidity only when market conditions make on-exchange inventory management unsuitable.

Keywords: exchange traded funds; market design; bid-ask spreads; liquidity provision; inventory management (search for similar items in EconPapers)
Date: 2019
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Working Paper: Liquidity provision in ETF markets: The basket and beyond (2019)
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