What is a Liquidity Waterfall in ETFs? Liquidity Waterfall Explained

Exchange-Traded Funds (ETFs) have come a long way since their inception in the early 1990s. Initially introduced as a cost-effective method to gain exposure to broad-market indices, ETFs quickly captured the attention of retail investors and institutional traders alike. Over the years, they have proliferated into various forms, targeting everything from niche sectors to specialized bond indices, alternative assets, and international markets.

Indeed, the variety of ETFs available today is staggering, reflecting the unceasing appetite of investors to slice the market into more precise segments. Yet, for all their innovation and diversity, one question consistently rises to the forefront: How do we assess an ETF’s liquidity? And what exactly does “liquidity” mean in the context of an ETF, especially when the underlying assets themselves might be far less fluid than the ETF suggests?

Enter the concept of the liquidity waterfall.

Liquidity Waterfall: ETFs

When traders discuss the liquidity of an ETF, they often focus on the “on-screen” volume—the daily traded shares and the bid-ask spreads. While that’s a helpful starting point, it’s only the tip of the iceberg. Beneath the surface lies a more intricate mechanism that underpins the entire ETF ecosystem, allowing even lightly traded ETFs to handle large buy or sell orders without massive price distortions. This deeper mechanism is commonly referred to as the liquidity waterfall, a layered structure that explains how ETF liquidity can extend beyond what’s visible at a glance.

Essentially, the liquidity waterfall delineates how an ETF’s liquidity sources stack together. At first, you have your typical secondary market trading, where you see quotes and volumes on the exchange. If that’s insufficient or priced inefficiently, the next layer involves “underlying liquidity,” tapping directly into the actual assets that compose the ETF’s basket. Lastly, the ultimate layer is the creation/redemption process that authorized participants (APs) utilize to keep ETF prices aligned with net asset value (NAV). This multiple-layer approach ensures that most ETFs can handle substantial trading volumes, at times far exceeding the on-screen figures, without dangerously wide spreads or drastic price gaps.

Why the Liquidity Waterfall Matters

A common misconception among investors is judging an ETF’s liquidity solely by its average daily volume or by observing the on-screen quote depth. This can be misleading, especially for emerging or specialized funds that don’t trade heavily on a daily basis. In reality, an ETF might appear “illiquid” if you only look at the standard metrics, yet it can facilitate large block trades if underlying assets or authorized participants step in. By understanding the concept of the liquidity waterfall, you can evaluate an ETF’s real trading capacity more accurately.

Furthermore, knowledge of the liquidity waterfall can empower you to avoid succumbing to fear when an ETF’s posted size looks small. Investors who realize that authorized participants can promptly create new shares once the underlying assets are available—or redeem them if outflows are large—recognize that the real “limit” to an ETF’s liquidity is rarely the daily on-screen volume. Instead, it’s the liquidity of the underlying market plus the willingness of APs to engage.

Understanding ETF Liquidity Basics

Defining Liquidity in ETFs

In finance, “liquidity” typically refers to how easily and rapidly an asset can be purchased or sold without significantly affecting its price. For a stock, high liquidity means tight bid-ask spreads and substantial trading volumes, whereas illiquid stocks tend to have wide spreads and thin volumes. When it comes to ETFs, liquidity is a bit more complex. An ETF’s “liquidity” spans beyond mere daily trading volumes or visible quotes. It includes the capacity for the market makers or authorized participants to rapidly create or redeem ETF shares, thereby smoothing out supply-demand imbalances.

On-screen liquidity relates to what you observe in the secondary market—the typical share trading on a stock exchange like the NYSE or NASDAQ. However, an ETF’s deeper liquidity might be hidden from immediate view and can be unlocked if institutional size orders appear, prompting market makers to hedge with underlying securities or to coordinate with authorized participants.

ETF Liquidity vs. Stock Liquidity

At first glance, an ETF might look like a stock in terms of how it trades: you see an order book with bids and asks, along with daily volume. But the similarity is superficial. A stock’s liquidity is intrinsically tethered to the total float and investor willingness to trade. Meanwhile, an ETF’s liquidity arises from two principal sources:

1. Secondary Market Liquidity: The ETF itself trades on an exchange. Investors buy and sell shares from each other, presumably at or near the ETF’s net asset value (NAV).
2. Primary Market Creation/Redemption: If trading supply or demand outstrips the on-screen liquidity, authorized participants can gather the underlying securities that constitute the ETF’s basket (for creation) or deliver ETF shares to redeem them (for redemption). This possibility tends to keep the ETF’s price close to its NAV, no matter the daily volume.

This dynamic means even an ETF with low average daily volume can handle large orders if the underlying market and the creation/redemption pipeline remain functional.

Importance of Liquidity for ETF Investors

1. Transaction Costs: Higher liquidity typically results in narrower bid-ask spreads. Tighter spreads reduce the cost of entering and exiting positions. For frequent traders, small differences in spreads can quickly add up.
2. Fair Pricing: If an ETF is highly liquid, the market price should remain close to NAV, minimizing premiums or discounts.
3. Ease of Scaling: A sufficiently liquid ETF can handle big trades from institutions, ensuring the fund can scale up or down without significantly moving the price.
4. Risk Management: Knowing an ETF’s deeper liquidity helps you better plan for possible portfolio rebalances, especially if market volatility increases or if you hold large positions.

Liquidity sets your flexibility.

Investors sometimes avoid certain ETFs if they see low daily volumes. Yet, with ETFs, that fear can be misplaced. The real measure of an ETF’s ability to handle large trades stems not just from secondary market quotes but from how effectively the underlying securities can be bought or sold. This leads us to the concept of the liquidity waterfall, which explains how on-screen volumes, underlying asset liquidity, and the creation/redemption mechanism all converge to shape what we might call “true ETF liquidity.”

What Is the Liquidity Waterfall?

The liquidity waterfall is essentially a layered explanation of how ETFs remain more liquid than might be evident from cursory metrics like on-screen trading volumes or order book depth. It highlights three primary “layers” or “levels” of liquidity:

1. On-Screen Liquidity: The secondary market trading visible in real-time.
2. Underlying Liquidity: The liquidity of the ETF’s underlying basket of securities (stocks, bonds, or other instruments).
3. Creation/Redemption Mechanisms: The process by which new ETF shares are created or existing shares are redeemed, bridging the gap between the ETF itself and its underlying assets.

Three layers ensure robust liquidity.

Concept Explained

Imagine you see an ETF that trades only 5,000 shares daily. You might think, “This ETF is illiquid. If I try to buy 50,000 shares, I’ll skyrocket the price.” But the liquidity waterfall says not so fast. There’s more to the story:

• First, you’d attempt to buy on-screen. The posted quotes might not accommodate your entire size at a tight spread.
• If more demand appears than the on-screen orders can handle, market makers or authorized participants can step in. They know they can hedge by purchasing or shorting the underlying shares that comprise the ETF. If the underlying securities are liquid, the authorized participants can create fresh ETF shares, fulfilling your large buy without drastically pushing up the ETF price.

This chain of actions ensures that the “real” capacity for trades is larger than any single day’s displayed volume might suggest. That’s the essence of the liquidity waterfall.

The Three Layers of the Liquidity Waterfall

1. On-Screen Liquidity

• Secondary Market: The direct trades you witness on your brokerage app or any exchange listing.
• Bid-Ask Spread: Typically narrower for frequently traded ETFs, but even if it’s wide, it might tighten if a large order appears.
• Depth of Book: Usually shows a snapshot of how many shares are offered at each price level, but for an ETF, some large or institutional orders might only materialize once a major buyer shows interest.

2. Underlying Liquidity

• Components: For an equity ETF, the “underlying” is a basket of stocks. For a bond ETF, it’s a collection of bonds. The crucial question is how easy it is to trade those assets in bulk.
• Pathway: If your big ETF trade can’t be matched on-screen, liquidity providers will look to the underlying securities. They can buy or sell those securities to hedge or facilitate your trade. If the underlying is highly liquid (like large-cap stocks), it’s straightforward to handle big volumes.
• Impact on Spread: The presence of a deep underlying market encourages narrower ETF spreads because market makers can quickly offset any inventory risk.

3. Creation/Redemption Mechanisms

• Authorized Participants (APs): Large financial institutions, often banks or broker-dealers, that have relationships with the ETF sponsor. They can deliver a basket of underlying assets to the ETF sponsor in exchange for newly created ETF shares (creation) or vice versa (redemption).
• Arbitrage: If the ETF’s price drifts too high above NAV, APs can step in by bringing underlying securities, creating ETF shares, and selling them, pushing the ETF price back to fair value. If the ETF trades below NAV, they can buy cheap ETF shares, redeem them for underlying assets, and sell those assets to make a risk-free profit, again realigning the price.
• Unlimited Potential: Provided the underlying market remains sufficiently liquid, an ETF’s share count can expand or contract as needed. This mechanism effectively sets an upper bound on how much an ETF’s price can deviate and how large a trade can be absorbed.

Waterfall ensures equilibrium.

Dynamic Interplay Between Layers

The liquidity waterfall is dynamic, responding to the size and urgency of trades:

• Small Orders: Typically absorbed at the top layer (on-screen) with minimal impact.
• Moderate Orders: If they exceed on-screen liquidity, market makers rely on the underlying markets to hedge. The cost of hedging determines how wide the ETF spread might go, but as long as underlying liquidity is healthy, the impact remains contained.
• Massive Orders: If really large trades surpass even the underlying’s immediate capacity, APs might create or redeem shares. This sets a fundamental “escape hatch,” ensuring no shortage of ETF shares if the demand is substantial.

Thus, no single layer is entirely responsible for an ETF’s liquidity. Instead, the synergy among them fosters a robust system where the final depth often surpasses what naive volume watchers might assume. This synergy also depends heavily on the vibrancy of the underlying market, which is why certain bond ETFs, especially those investing in less liquid corners like high-yield or emerging market debt, face more potential liquidity concerns.

How the Liquidity Waterfall Functions in Practice

The concept of an ETF liquidity waterfall might sound theoretical, but it has concrete implications for day-to-day trading and occasional extreme market conditions. By seeing how each layer responds under typical markets vs. stress events, you can glean insight into how your own orders might execute. Moreover, this section clarifies how authorized participants, underlying markets, and on-screen trades come together in real time.

Let’s see the waterfall in action.

Normal Market Conditions

Under average or calm market conditions, an ETF’s on-screen liquidity often suffices for everyday trading activity. For popular equity ETFs—like those tracking major indexes—daily volumes can number in the millions of shares, with penny-wide spreads. Even niche ETFs might have narrower markets than you’d expect because a designated market maker stands ready to quote both sides.

Here’s a typical scenario: A retail investor attempts to buy 1,000 shares of an ETF. The posted ask might have 2,000 shares. The trade executes quickly with minimal spread impact. The liquidity waterfall’s deeper levels remain mostly dormant because that modest size didn’t challenge the system.

Now suppose a small institutional desk wants 50,000 shares of an ETF that only prints, say, 10,000 shares a day. Initially, you might assume such an order would push the price up. But in reality, a market maker can quickly hedge by purchasing the underlying basket or shorting it if the trade is the reverse (a sell). Then, if needed, they coordinate with authorized participants. The end result is often that the big trade is filled at a narrower spread than the daily volume would suggest possible.

Layers remain quietly ready.

Stress Scenarios

Significant Market Volatility

During abrupt market downturns or radical news events—like a major geopolitical shock—some investors panic-sell. ETFs might see a spike in redemptions or a surge in sell orders. If the underlying securities are also experiencing dislocations, the top-tier on-screen liquidity can evaporate quickly, leading to wider spreads. Then the second layer (underlying liquidity) and the creation/redemption processes matter:

• Example: In a meltdown, an ETF’s on-screen quotes could temporarily reflect a discount to NAV if risk-averse market makers step away. But as soon as that discount becomes too large, APs find it profitable to buy the cheap ETF shares, redeem them, and collect the underlying assets, thus restoring prices closer to NAV.
• Volatility: The big question is whether the underlying assets are likewise liquid. If they are, APs can proceed with arbitrage with less friction. If they’re illiquid (like certain bonds or small-cap stocks), the entire system might see liquidity degrade, generating bigger discounts or premiums for a time.

Large Sell Order on a Thinly Traded ETF

Another scenario: A big investor wants to offload a large chunk of a less mainstream ETF that invests in, say, emerging market local currency bonds. The daily on-screen volume is minimal, so the immediate top layer is insufficient. The market maker looks at the underlying bond markets, which themselves may not be particularly deep, especially if there’s a local crisis in that emerging market. In such a case:

• AP’s Role: The AP might step in to redeem those ETF shares, effectively unloading the underlying bonds if it’s feasible. If the bond market is also chaotic, they demand a wide spread to reflect the difficulty.
• Possible Temporary Discount: During the time it takes to unwind or find counterparties in the bond market, the ETF might temporarily trade below NAV if liquidity is fleeting. Over hours or days, it should realign once sellers are accommodated and new buyers appear.

The liquidity waterfall can still function, but it might not be as smooth or tight as in normal conditions. That’s one reason that some smaller or specialized ETFs can see fleeting but sharp dislocations in extreme markets—underlying security liquidity, or lack thereof, can hamper the system’s normal equilibrium.

The system works, but can get bumpy.

Examples of High-Volume ETF Trades

Real-world accounts abound of institutional traders placing multi-million-dollar ETF orders. On-screen volumes might only be in the tens of thousands of shares daily, yet the trades still happen with minimal market disruption. Why? Because:

• A block desk at a major broker might pre-arrange the transaction, coordinating with authorized participants or large specialized market makers.
• The aggregator or broker obtains the underlying securities if needed, or sells them if it’s a redemption, ensuring the overall net effect is small on the ETF price.
• Gains from the creation/redemption arbitrage keep the ETF from deviating too far from its NAV. If too high, new shares are created; if too low, shares are redeemed.

Such episodes reinforce the message that daily volume doesn’t always define an ETF’s real capacity for trades. The multiple layers—top-level quotes, underlying securities, and creation/redemption—collectively “absorb” large trades in a surprisingly elastic manner.

Big trades rely on deeper layers.

Price Distortions and The Lifeline

If all else fails—meaning the on-screen liquidity is meager, and even the underlying assets are not especially fluid—the system’s final recourse is pricing that widens the spreads. The liquidity providers, if they sense significant risk in handling large transactions, will quote wider to mitigate potential losses. The net effect is that if an investor insists on immediate execution, they might pay a bigger premium or accept a deeper discount. Over time, however, the creation/redemption process still anchors the ETF near NAV, though friction can cause short-lived divergences.

In sum, whether it’s a typical calm day or a hectic meltdown, the liquidity waterfall ensures that an ETF’s capacity to handle trades extends beyond superficial volumes. Yet, that advantage is not always guaranteed—especially if the underlying markets themselves freeze up or if authorized participants fail to operate.

Benefits and Risks of the Liquidity Waterfall

The liquidity waterfall grants ETFs a special edge, ensuring that even lightly traded funds may in fact be quite liquid when the right conditions exist. This layered approach provides a safety net for normal market times, letting big trades slip in with minimal drama. However, no system is without potential failure points, and the waterfall can run dry if certain layers fail or if the underlying assets are structurally illiquid. In this section, we’ll explore these benefits and risks in more detail.

Pros and cons exist.

Benefits

1. Efficient Trading

The prime advantage is that an ETF can handle trading volume well in excess of what the daily stats might suggest. This efficiency arises from:

• On-Screen Market: For smaller retail orders, tight spreads often suffice.
• Underlying Asset Liquidity: For moderate institutional orders, market makers seamlessly hedge in the underlying to fill the trades.
• Creation/Redemption: For very large block trades, new ETF shares can be created or redeemed swiftly, ensuring no major price dislocation.

In essence, the system draws liquidity from multiple tiers, meaning large trades can happen at or near NAV without wide or persistent discounts/premiums.

Multiple layers = fewer big price moves.

2. Scalability

This layered structure fosters scalability. If investor demand surges for a certain ETF, the creation mechanism can expand the share count. The ultimate limitation isn’t the ETF itself but the size and openness of the underlying market. For broad equity ETFs, that limit can be huge, accommodating billions in inflows. For narrower markets—like a frontier bond fund—scalability might be more constrained, but there’s still a creation/redemption lifeline to ensure systematic supply or removal of shares.

3. Pricing Transparency

While the liquidity waterfall can appear opaque if you only look at the top-level trades, sophisticated participants understand that the ETF’s net asset value (NAV) is typically visible and updated throughout the day (intraday indicative value, iNAV). This availability helps keep final trades in line with the real value of underlying assets. If the market sees an ETF drifting away from iNAV, authorized participants can arbitrage, pulling the price back in line. This dynamic fosters a sense of fairness and consistency for most investors.

4. Risk Diversification for Market Participants

Market makers, dealing with large orders, can offset risk by tapping the underlying or the creation/redemption process. This arrangement encourages them to quote narrower spreads and be comfortable providing liquidity, knowing that if an outsize buy or sell surfaces, they aren’t stuck with an unhedgeable position. This leads to a more stable and predictable marketplace for all parties.

Risks

1. Underlying Asset Illiquidity

Perhaps the most pressing risk is if the underlying securities are themselves illiquid. If an ETF invests in a narrow or shallow market, such as high-yield municipal bonds or niche emerging-market stocks with limited float, creation/redemption becomes more challenging. During times of market stress, APs might be reluctant or unable to easily buy or sell large chunks of those underlying assets. The entire waterfall can then jam, leading to:

• Discounts or Premiums: The ETF trades at a discount if many are selling and APs can’t feasibly redeem or hedge quickly. Or at a premium if many are buying but the underlying is too tight for APs to do straightforward arbitrage.
• Wider Spreads: Market makers, seeing potential trouble hedging, will quote defensive spreads.

If the base is shaky, the waterfall’s strength declines.

2. Market Disconnects in Stress Periods

While an advantage of the liquidity waterfall is to maintain calm, in severe crises (e.g., the 2008 financial meltdown or the early days of the COVID-19 pandemic in March 2020), liquidity can dry up across the board. APs might step back from creation/redemption if the underlying environment is extremely uncertain. At times, we’ve seen bond ETFs trade at noticeable discounts due to temporarily frozen bond markets. This underscores that the waterfall relies on stable participants for each layer, and if they retreat, the cascade effect can break down.

3. Dependence on Authorized Participants

Authorized participants are crucial to bridging the gap between the ETF and underlying. If, for any reason, they decide not to engage—perhaps the risk is too high or they face internal constraints—the entire system can falter. While typically multiple APs support a single ETF, meaning it’s not reliant on just one firm, a coordinated or broad pullback can challenge the normal checks and balances.

4. Complexity and Misunderstanding

For average retail investors, the intricacies of the liquidity waterfall can remain opaque, leading some to make poor decisions. Investors might be spooked by low average volumes, not realizing the deeper liquidity capacity. Others might assume unlimited liquidity, ignoring potential pitfalls if the underlying is fundamentally illiquid. Such misperceptions can cause overconfidence or undue caution, either missing good opportunities or incurring unexpected friction.

Education is crucial for using ETFs well.

Summarizing the Net Impact

On balance, the liquidity waterfall provides a significant benefit: it allows ETFs to handle big trades with minimal disruption and keeps their prices tethered to underlying value. However, that advantage rests on an environment where underlying assets remain decently liquid and participants remain active. During normal times, it’s impressively effective. During severe stress, it can be tested. Knowing these upsides and downsides arms you with a more realistic perspective when evaluating or trading an ETF, especially one that might appear illiquid on the surface.

Conclusion

The liquidity waterfall stands at the heart of what makes ETFs so compelling to a wide range of investors. By showcasing how ETF shares can handle big orders and remain close to NAV—despite sometimes modest daily on-screen volumes—it dispels the myth that an ETF’s liquidity is limited purely by what appears on the exchange’s order book. Instead, we realize there are effectively three layers that combine to ensure efficient trading:

1. On-Screen Liquidity: The visible trading environment where everyday secondary-market transactions occur, revealing the immediate depth and bid-ask spreads.
2. Underlying Liquidity: The capacity of market makers or authorized participants to hedge or source large blocks of the ETF’s component securities in the primary market.
3. Creation/Redemption Mechanisms: The final backstop that aligns the ETF’s supply with demand, letting authorized participants create new shares or redeem existing ones based on the basket of underlying assets.

A three-tier system keeps ETFs aligned with reality.

Key Takeaways for Investors

• Beyond Daily Volume: Don’t judge an ETF’s liquidity solely by its average daily trading volume or visible quotes. This can be deceptive, especially for newly launched or specialized funds that might not see robust daily trades.
• Look at Underlying Markets: If the ETF invests in highly liquid large-cap equities or Treasuries, the real liquidity is often extensive. If it invests in thinly traded bonds or frontier stocks, caution is warranted.
• Assess Stress Scenarios: Even well-structured ETFs can see spreads widen in major market turbulence if underlying securities freeze. The entire waterfall process depends on functioning primary markets and engaged authorized participants.
• Leverage the Creation/Redemption: The knowledge that shares can be created or redeemed by authorized participants should give you confidence that an ETF’s actual capacity for large trades extends beyond superficial metrics, provided the underlying is healthy.

Final Thoughts

ETFs have transformed from a niche indexing tool into a linchpin of modern markets, offering convenient, cost-efficient exposure to countless asset classes. The liquidity waterfall is a crucial piece of their success, enabling robust liquidity that frequently surpasses initial expectations. By layering on-screen quotes, underlying markets, and the creation/redemption mechanism, ETFs can offer near-limitless scale. That said, no system is foolproof; underlying asset liquidity can hamper the waterfall’s flow, and in times of crisis, authorized participants might retreat. Knowledge of these intricacies helps you approach ETF investing with nuance, distinguishing truly resilient funds from those that might falter in rough seas.

Remember: If you’re evaluating an ETF, look at more than daily trade volumes. Investigate the nature of its underlying holdings, the presence of multiple authorized participants, and how consistently it trades near NAV under various conditions. Ultimately, harnessing a thorough understanding of the liquidity waterfall can lead to more confident, strategic decision-making in ETF selection and usage, whether for short-term tactical trades or long-term portfolio construction.

Important Information

Investment Disclaimer: The content provided here is for informational purposes only and does not constitute financial, investment, tax or professional advice. Investments carry risks and are not guaranteed; errors in data may occur. Past performance, including backtest results, does not guarantee future outcomes. Please note that indexes are benchmarks and not directly investable. All examples are purely hypothetical. Do your own due diligence. You should conduct your own research and consult a professional advisor before making investment decisions. 

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