Liquidity and Price Discovery in Exchange-Traded Funds:
One of Several Possible Lessons from the Flash Crash

Abstract

Exchange-traded funds as a class were more affected by the flash crash of May 6 than any other category of securities. The authors connect the debates over the linkages between exchange-traded funds and the broader market, and a potentially severe mismatch in liquidity,by asking the question: How did liquidity provision affect price discovery in the market for exchange-traded funds? They provide evidence that price discovery failed dramatically for this class of securities during the crash, and that the proximate cause was an extreme deterioration in liquidity, both in absolute terms and relative to individual securities in the baskets tracked by the funds. Their results are consistent with market participants’ behavior in terms of liquidity provision, but not with conjectures concerning a failure in market structure or in the exchangetraded fund product.

TOPICS: Exchange-traded funds and applications, financial crises and financial market history, in markets