Impact of arbitrage between leveraged ETF and futures on market liquidity during market crash

TL;DR

This study uses artificial market simulations to examine how arbitrage trading between leveraged ETFs and futures affects market liquidity during crashes, revealing liquidity flows depend on where erroneous orders occur.

Contribution

It provides novel insights into the impact of arbitrage on liquidity dynamics between leveraged ETFs and futures during market crashes.

Findings

Arbitrage causes liquidity to flow from futures to ETFs when ETF orders are erroneous.

Arbitrage causes liquidity to flow from ETFs to futures when futures orders are erroneous.

Liquidity is supplied from futures to ETFs in terms of Volume, SellDepth, and Tightness during crashes.

Abstract

Leveraged ETFs (L-ETFs) are exchange-traded funds that achieve price movements several times greater than an index by holding index-linked futures such as Nikkei Stock Average Index futures. It is known that when the price of an L-ETF falls, the L-ETF uses the liquidity of futures to limit the decline through arbitrage trading. Conversely, when the price of a futures contract falls, the futures contract uses the liquidity of the L-ETF to limit its decline. However, the impact of arbitrage trading on the liquidity of these markets has been little studied. Therefore, the present study used artificial market simulations to investigate how the liquidity (Volume, SellDepth, BuyDepth, Tightness) of both markets changes when prices plummet in either (i.e., the L-ETF or futures market), depending on the presence or absence of arbitrage trading. As a result, it was found that when erroneous orders occur in the L-ETF market, the existence of arbitrage trading causes liquidity to be supplied from the futures market to the L-ETF market in terms of SellDepth and Tightness. When erroneous orders occur in the futures market, the existence of arbitrage trading causes liquidity to be supplied from the L-ETF market to the futures market in terms of SellDepth and Tightness, and liquidity to be supplied from the futures market to the L-ETF market in terms of Volume. We also analyzed the internal market mechanisms that led to these results.