What drives the effects of exchange-traded funds on their underlying assets?

Exchange-traded funds (ETFs) have observed an explosion following a economic crisis, with $7 trillion in assets under management worldwide by August 2020 (ETFGI 2020). Their recognition is attributed that they provide investors an affordable method to gain contact with a multitude of asset classes, coupled with intraday liquidity by permitting their shares to become continuously traded on exchanges.

A mix of line and bar charts showing Figure 1. Global ETF assets under management growth

Figure 1: Global ETF assets under management growth

Source: ETFGI 2020.

The ETF marketplace is split up into two segments. However market, a select number of market participants known as approved participants (APs) trade directly using the ETFs, creating or redeeming ETF shares in return for cash or even the underlying securities. Within the secondary market, other investors can trade ETF shares on exchanges or higher-the-counter. APs make money from their own positioning however market by exploiting arbitrage possibilities as a result of deviations of ETF share prices from the need for the actual portfolio, thus making certain the close alignment of these two.

The development of ETFs has sparked a debate across industry practitioners, academics, and policy makers on whether ETFs lead to smooth market functioning, especially during occasions of stress. Within the recent market turmoil of March 2020, ETFs have the symptoms of acted as cost discovery mechanisms, specifically for illiquid underlying securities for example corporate bonds, as investors traded the greater liquid ETF shares rather (Bank of England 2020 Aramonte and Avalos 2020). Yet, in the past instances, like the flash crash of 2010, it’s been contended that ETFs propagated liquidity shocks towards the underlying equities (Commodity Futures Buying and selling Commission and Registration 2010). Hence, the controversy is not resolved and comprehending the mechanism by which ETFs modify the underlying securities is vital because they more and more dominate the markets that they invest.

To reveal this mechanism, within my paper, co-authored with Pawel Fiedor in the Central Bank of eire, we make use of a unique proprietary data group of the Central Bank of eire that contains all Irish ETFs as well as their holdings to check out the results of Irish ETFs around the liquidity, prices, and volatility of the underlying equities and company debt securities. Ireland may be the primary hub of ETFs within the euro area, with Irish ETFs managing €424 billion in assets by September 2018, about 2-thirds from the euro area total.

The wealthy data set enables us to operate panel regressions in the underlying security level on the daily frequency, to evaluate the results of ETFs while controlling for a number of additional factors, including security and time fixed effects. We run the regressions for every underlying asset class individually, to know the differential impacts of ETFs in it.

Our primary findings could be summarized the following. First, ETFs propagate liquidity shocks towards the underlying equities although not towards the underlying corporate debt securities, and therefore when ETFs become illiquid, this could also negatively modify the liquidity of equities but doesn’t have impact on the liquidity of corporate debt securities. Second, when demand shocks hit the ETF share prices, they may also strongly modify the prices of equities only possess a weak impact on the costs of corporate debt securities. Third, greater ETF possession of equities increases their volatility, but greater ETF possession of corporate debt securities decreases their volatility.

To know why such differential effects occur over the two underlying asset classes, we depend on the theoretical framework that appears at links between assets which are created via information channels. Information links are created when investors use information in one focal point in cost another (Cespa and Foucault 2014). We reason that ETFs form similarly info links using the underlying securities with the activity of APs who continuously exploit arbitrage possibilities backward and forward markets. However, the quality of arbitrage activity and also the resulting strength from the information link rely on the ease of access from the underlying assets. When the underlying securities are easy-to-do business with small transaction costs, for example exchange-traded equities, this facilitates the game of APs and helps to create a powerful information link. However, when the underlying securities are difficult-to-do business with significant search and transaction costs, for example over-the-counter-traded corporate debt securities, this limits ale APs to take advantage of arbitrage possibilities, thus developing a weak information link to the ETFs and restricting the transmission of shocks.

The suggested mechanism of knowledge links and our empirical findings are in line with how ETFs have socialized in the past periods of stress. Based on Commodity Futures Buying and selling Commission and Registration (2010), when SPY, the biggest US ETF tracking the S&P 500 index, grew to become illiquid and endured cost declines within the flash crash of 2010, the marketplace makers within the underlying equities elevated their quoted bid-ask spreads or stopped intermediating entirely because they grew to become uncertain about the need for the securities, a minimum of as reflected within the ETF share cost. Quite simply, the strong information link broke lower during stress, which propagated the liquidity shock in the ETF towards the underlying equities. More lately, in March 2020, many corporate bond ETFs were buying and selling in particular discounts for their underlying securities because the latter grew to become completely illiquid as well as their prices continued to be stale while investors traded ETF shares rather. The demand shocks striking the ETF share prices weren’t being transmitted towards the underlying corporate debt securities due to their inaccessibility, that is a symbol of the weak information link that exists backward and forward markets because the information contained in the ETF shares wasn’t being integrated into the actual securities.

Our paper plays a role in the controversy on whether ETFs facilitate smooth market functioning by quarrelling it depends upon the ease of access from the underlying markets, which determines the effectiveness of the data link that’s created backward and forward. This will be significant from the policy perspective because it sheds light around the mechanism by which ETFs can propagate shocks towards the underlying securities through various channels, including their liquidity, prices, and volatility. As ETFs keep growing, their systemic importance increases, so it’s crucial to acquire a holistic look at how they may propagate shocks, and our paper plays a role in this goal.

The views expressed within this blog publish and paper are individuals from the authors only and never from the Central Bank of eire or even the ESCB.


Aramonte, S. and Avalos, F. (2020). The current distress in corporate bond markets: cues from ETFs. BIS Bulletin No. 6.

Bank of England (2020). Interim Financial Stability Report May 2020.

Cespa, G. and Foucault, T. (2014). Illiquidity Contagion and Liquidity Crashes. Overview of Financial Studies, 27(6):1615-1660.

Commodity Futures Buying and selling Commission and Registration (2010). Findings concerning the market occasions of May 6, 2010.

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