Liquidity and Risk Sharing Benefits from the Introduction of an ETF

This article examines how the introduction of an ETF replicating a stock index impacts on the liquidity of the underlying stocks. We find that index stock spreads decline, relative to those of non index stocks, after the introduction of the ETF. Changes in adverse selection do not appear to be a major factor explaining this liquidity improvement. We also fail to relate it to recognition effects. By contrast, we think that it can mainly be explained by a decrease in order processing and order imbalance costs. This is consistent with the arbitrage theory of Fremault (1991) according to which increased cross-market trading provides additional risk sharing capacity.