Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/311136 
Year of Publication: 
2024
Series/Report no.: 
ESRB Working Paper Series No. 149
Publisher: 
European Systemic Risk Board (ESRB), European System of Financial Supervision, Frankfurt a. M.
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.
Subjects: 
exchange-traded funds
liquidity transformation
custom baskets
JEL: 
G12
G14
G18
D47
Persistent Identifier of the first edition: 
ISBN: 
978-92-9472-393-2
Document Type: 
Working Paper

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