How does ETF liquidity work?

ETF liquidity – everyone wants it, and sure enough, the most common questions clients ask us at ETF Securities are about liquidity. Investors want assurance that ETFs will trade cheaply and smoothly. And know they always sell, even in volatile markets.

In this episode, I spoke with Robert Risk, from Susquehanna. Susquehanna is a private-held securities trading firm – often referred to as a “market maker”, in finance jargon. Market makers work with ETF providers – like us at ETF Securities – and with stock exchanges – like Chi-X and the ASX – to ensure that ETFs trade smoothly throughout the trading day. Market makers like Susquehanna are a critical part of the ETF market. But they are often a background presence, known only to industry insiders. In this video, Robert lifts the lid on market making. He starts by walking us through the history of Susquehanna, which started out as an options trading company in Philadelphia in 1987.

Today, Susquehanna trades over 2,000 ETFs in the US and in Europe and around 200 in Australia. When investors log onto their CommSec or Nabtrade account and look at the prices for ETFs – what is called the “bid and offer spread” – Susquehanna will often be one of the companies providing the pricing and the liquidity. Often unknown to investors, whenever they buy or sell an ETF on their brokerage accounts, they are often transacting with Susquehanna.

The role of Market Makers in ETF's supply and demand

How is Susquehanna able to trade so many ETFs at the same time all day long? Robert explains that it is Susquehanna’s investment in technology and people which allows it to calculate the fair value – called the net asset value, or “NAV”, in another piece of jargon – across the multiple ETFs that it trades.

I ask Robert about concerns that investors sometimes have about ETF liquidity. Can ETFs trade at the wrong price when markets become volatile? And is there a risk that ETFs stop trading altogether in unstable markets?

Robert answers that ETFs are open-ended funds, meaning the number of ETFs in existence can increase or decrease with on-market trading activity. This open-endedness allows supply to be changed to match demand. Supply of an ETF can be reduced when investor demand dries up—to avoid the risks of ETFs trading at discounts, and supply can be added when demand increases—to avoid the risks that ETFs trade at premiums. Susquehanna works with ETF providers to facilitate the flow of these ETFs.

He says that this worked very well during the coronavirus sell-off in March 2020. The worst of the volatility over that period resulted in an average market move of 3.5% a day – an unprecedented level of share market volatility. And yet the ETF market held together well, Robert says.

I give Robert an anecdote of my own. After the drawdowns of 2020, a client of ours at ETF Securities who traditionally used managed funds started to look into ETFs. This is because he believed that ETFs provide more reliable pricing. As ETFs trade during the day, they can incorporate new information more quickly than managed funds.

At the end of our interview, I asked Robert if he had any tips investors should know when trading ETFs?

He says investors should do their research into what they are investing in, be aware of what underlying assets the ETF holds. ETFs can hold very different assets – some are geared ETFs that hold futures on margin. While others are more vanilla and track famous share market gauges like the ASX 200. 

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