Evaluating the Impact of Exchange-Traded Funds on Market Liquidity and Price Discovery Efficiency
Posted: Apr 30, 2023
Abstract
The proliferation of Exchange-Traded Funds (ETFs) represents one of the most significant financial innovations of the past two decades, fundamentally transforming investment landscapes and market microstructure. While extensive literature has documented the growth and basic mechanics of ETFs, a comprehensive understanding of their nuanced impact on market quality remains elusive. Traditional research has largely approached ETFs through conventional asset pricing frameworks, often yielding contradictory conclusions about their effects on liquidity and price discovery. This study breaks from established paradigms by introducing a novel analytical framework that captures the complex, non-linear relationships between ETF activity and market efficiency metrics. Our research addresses a critical gap in the literature by examining how ETFs simultaneously function as both liquidity providers and potential sources of market fragility. The conventional narrative posits ETFs as unequivocally beneficial for market quality through enhanced arbitrage opportunities and improved price discovery. However, this perspective fails to account for the structural complexities and potential externalities introduced by ETF proliferation. We challenge this simplified view by demonstrating that ETF impacts are highly conditional on market structure, asset class characteristics, and temporal factors. The central research questions guiding this investigation are threefold. First, how do ETFs influence market liquidity across different asset classes and market conditions? Second, to what extent do ETFs contribute to or detract from price discovery efficiency in underlying securities? Third, what are the threshold effects and non-linear relationships in the ETF-market quality dynamic? These questions are explored through an innovative methodological approach
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