Exchange-Traded Funds (ETFs) and Systemic Risk

This essay focuses the factors that make ETFs and trading in them unique – at times uniquely risky. Following a deep dive into the microstructure of ETFs, I zoom in on the potential systemic risks associated with ETFs, with a focus on the legal structure and, in particular, the arbitrage channel. Drawing on insights from the literature, this essay posits that the microstructure underlying the arbitrage mechanism inherent to ETFs, rather than the more conventional channel of massive demand redemption alone, can pose systemic risk. Specifically, I argue that the close relationship between the participants involved the management and trading of ETFs, which tend to be global systemically-important banks (G-SIBs), means that stress in the ETF markets can easily spill over into the broader financial system.