Operational Shorting and ETF Liquidity Provision

Due to a regulatory exemption, ETF market makers can satisfy excess demand in secondary markets by selling ETF shares that have not yet been created. While this ability to “operationally short” is not unique to ETFs, it plays a more prominent role in ETF liquidity provision, and results in elevated ETF failures-to-deliver. We propose a novel measure for “operational shorting” and show it is associated with improved liquidity and greater price efficiency in the ETF underlying securities. Higher retail trading activity and short-term return reversals are also consistent with liquidity-supplying motives rather than informed trading. Consequently, delayed ETF creation to cover operational shorts is found to be a valuable option in the presence of retail trading and liquidity mismatches between the ETF and its underlying securities