How Does the Introduction of an ETF Market with Liquidity Providers Impact the Liquidity of the Underlying Stocks?

This article examines how the inception of an ETF market where liquidity providers (LPs) act as market makers, impacts the liquidity of the ETF-underlying-index stocks. Using detailed data from Euronext Paris, we find that: (1) trading costs in the ETF market are significantly lower than those observed in the market for the underlying stocks, and show that ETF LPs are largely responsible for this cost reduction; (2) the market for the underlying stocks becomes more liquid after the ETF introduction for investors who trade at the best-limit quotes; (3) but the stock market becomes less deep for larger traders, most probably because some large liquidity traders exit the underlying stocks’ market for the ETF market.