New Developments in Long-Term Asset Management
May 19-20, 2017
ETF Arbitrage under Liquidity Mismatch
As one of the fastest-growing asset classes, exchange-traded funds (ETFs) have been increasingly invested in illiquid assets. A natural liquidity mismatch emerges when liquid ETFs hold relatively illiquid assets. Kevin Pan of Harvard University and Yao Zeng of the University of Washington theorize and present empirical evidence, in the particular context of corporate bond ETFs, that this liquidity mismatch can reduce market efficiency and increase fragility. They leverage two key institutional frictions: the liquidity mismatch, and the dual role of authorized participants (APs) as both bond dealers and the only arbitragers able to create and redeem ETF shares. [Download the paper]
Other Conference Papers
Institutional Investors and Information Acquisition, Matthijs Breugem and Adrian Buss
Pan and Zeng propose a theoretical framework showing that APs' ETF creation and redemption motives are influenced by two opposing effects: an arbitrage effect and an inventory management effect. When the absolute magnitude of inventory imbalances of APs (also as bond dealers) is small, APs use ETF creations and redemptions to close bond-ETF relative mispricings. APs are willing to close relative mispricings when the marginal benefit of expected arbitrage return outweighs other costs. However, ETF arbitrage remains far from frictionless and is limited by the liquidity mismatch. In contrast, when the absolute magnitude of APs' bond imbalances is large, the inventory management effect, which captures the motive to trade towards an optimal bond inventory level, rises. While APs still create and redeem ETF shares, ETF arbitrage may go in the opposite direction to what would be implied by the initial relative mispricing. Intuitively, APs may strategically use ETF creations and redemptions not to correct relative mispricings, but to unwind bond imbalances, reduce existing inventory risks and facilitate future market-making in their role as bond dealers. In this sense, the ETF arbitrage mechanism becomes "distorted" — creations and redemptions are disconnected from fundamentals — and gives rise to the possibility of larger relative mispricings.
Second, bond inventory generates unique risks to ETF arbitrage through the inventory management effect. When APs experience larger bond inventory imbalances, APs' creation and redemption activities become less sensitive to perceived arbitrage opportunities, and more sensitive to the size of their bond inventory imbalances.