Liquidity Dynamics of Exchange-Traded Funds in Developing Markets

Abstract

Market liquidity remains a significant challenge in emerging markets, hindering the development of capital markets. To address this issue, there have been suggestions that innovations, such as new asset classes, could help alleviate market frictions. Exchange Traded Funds (ETFs) have emerged as an asset class that has gained traction over the past few decades in developed markets and is now gaining acceptance in emerging markets. The increasing use of ETFs has led to a diversification of investor types, investment strategies, and investment classes, which has sparked academic and policy interest in this investment instrument. The purpose of this research is to analyse the effects of ETFs on capital markets, with a particular focus on liquidity, which has often eluded emerging economies. To achieve this aim, three objectives are addressed: first, to analyse how the introduction of ETFs has impacted liquidity; second, to explore the liquidity risk associated with ETFs; and third, to examine the effects of ETFs on market efficiency. The analysis reveals that, in most countries studied, ETFs are associated with a reduction in liquidity. Further cross-sectional analysis indicates a shift in the financial market architecture. The study also demonstrates a moderate to high liquidity risk during periods of market turmoil. The final objective highlights transitory effects of ETFs where ETFs play different roles in the price formation process, with varying impacts on short- and long-run efficiency. Consequently, the results align more closely with the Adaptive Market Hypothesis rather than the Efficient Market Hypothesis. The findings of this study suggest a need for a renewed emphasis on maintaining market integrity, stability, and investor protection. This may necessitate new regulations or increased oversight to effectively address the evolving landscape of ETF-influenced markets.