The Provision of Liquidity in ETFs: Theory and Evidence from European Markets

ETFmarkets generally provide high levels of liquidity but occasionally break downunder turbulent conditions. We show that this seemingly ambivalentbehavior can optimally arise in an inventory model of market making that explicitly accounts for the ETFspecific dual trading structure. Our model predicts that ETFspreads are increasing in market makers' risk aversion, underlying index volatility and benchmark stock basket illiquidity. Consistent with our model, we find that spreads on European equity ETFmarkets are determined by inventory risk-related variables. However, the benchmark stock basket’s liquidity matters only when market conditions do not allow for efficient inventory management.