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Microstructure implications of ETF arbitrage with custom baskets

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  • Körükmez, Berke

Abstract

Exchange-traded funds (ETFs) are typically considered to be passive investment vehicles designed to track a benchmark index. However, with the promulgation of the Securities and Exchange Commission’s 2019 ETF Rule, funds are permitted the use of custom creation/redemption baskets. This change effectively enables a form of active basket management during the ETF’s arbitrage process. In this paper, I show that the uptake of custom baskets has heterogeneous effects on the microstructure of corporate bond ETFs. While custom baskets enhance the liquidity transformation of bond ETFs, this comes at a cost, as they concurrently produce larger index tracking errors. To isolate these effects empirically, I exploit the 2019 ETF Rule as a quasi-natural experiment. My findings substantiate the presence of a trade-off between liquidity enhancement and tracking error minimization, and underscore the role of custom baskets as contributors to this trade-off. JEL Classification: G12, G14, G18, D47

Suggested Citation

  • Körükmez, Berke, 2025. "Microstructure implications of ETF arbitrage with custom baskets," ESRB Working Paper Series 149, European Systemic Risk Board.
    • Handle: RePEc:srk:srkwps:2025149
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    File URL: https://www.esrb.europa.eu//pub/pdf/wp/esrb.wp149.en.pdf
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    More about this item

    Keywords

    custom baskets; exchange-traded funds; liquidity transformation;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • D47 - Microeconomics - - Market Structure, Pricing, and Design - - - Market Design

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