Liquidity provision in the Exchange Traded Fund market

Abstract

Liquidity in Exchange Traded Funds (ETFs) deteriorates when intraday tracking error increases. This negative association is causal and primarily driven by ETF designated market makers (DMMs) reducing their liquidity provision in response to higher levels of intraday tracking error. On days with primary market arbitrage activities, DMMs decrease liquidity provision and actively engage in liquidity taking. Intraday rather than end-of-day tracking error drives these primary market arbitrage activities. This suggests DMMs act as if there is a higher risk of trading against informed traders, such as primary market arbitrageurs, when the intraday tracking error is high.

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