How ETFs Stay Liquid: The Hidden Role of Market Makers and Arbitrage

After writing my first blog on ETF in-kind seeding, a few follow-up questions kept coming up—especially from people who invest in ETFs but don’t work in the ETF ecosystem:

• How do ETFs stay so liquid?

• Why don’t ETF prices drift far from their actual value?

• How can an ETF with low trading volume still trade efficiently?

The short answer is: ETF liquidity is engineered, not accidental.

And at the center of that engineering are market makers, authorized participants, and arbitrage—a system that quietly keeps ETFs working the way investors expect, even during volatile markets.

This blog walks through how that system actually works.

The Common Misconception About ETF Liquidity

Many investors assume:

If an ETF doesn’t trade much, it must be illiquid.

That assumption is often wrong.

Unlike stocks, ETF liquidity doesn’t primarily come from trading volume. It comes from the liquidity of the underlying securities and a mechanism that allows supply to expand or contract as needed.

This is one of the most misunderstood aspects of ETFs.

Two Markets, One ETF

Every ETF operates across two interconnected markets:

1️⃣ Secondary Market (What Most Investors See)

• ETFs trade on exchanges like stocks

• Investors buy and sell ETF shares

• Prices fluctuate throughout the day

  
  

2️⃣ Primary Market (What Keeps Things in Line)

• Large institutions interact directly with the ETF

• ETF shares are created or redeemed

• This is where arbitrage happens

The second market is what keeps the first one honest.

The Role of Market Makers and Authorized Participants

Market makers and authorized participants (APs) are typically large banks or trading firms. Their job is not directional investing—it’s price efficiency.

They:

• Quote tight bid-ask spreads

• Monitor ETF price vs underlying value

• Step in when prices diverge

They are incentivized by arbitrage, not speculation.

How Arbitrage Keeps ETF Prices in Check

Let’s walk through a simple example.

Scenario 1: ETF Trades Above Its True Value (Premium)

1. ETF market price rises above its NAV

2. AP delivers the underlying securities (in-kind)

3. New ETF shares are created

4. AP sells those shares in the market

5. Increased supply pushes the price back down

Scenario 2: ETF Trades Below Its True Value (Discount)

1. ETF trades below NAV

2. AP buys ETF shares cheaply

3. Redeems them for underlying securities

4. ETF shares are removed from circulation

5. Reduced supply pushes the price back up

In both cases, profit-seeking arbitrage restores balance.

No committee. No intervention. Just incentives doing their job.

Why ETF Liquidity Is Different from Stock Liquidity

For stocks:

• Liquidity depends on how often the stock trades

For ETFs:

• Liquidity depends on how liquid the underlying basket is

This is why:

• A bond ETF can remain liquid even when individual bonds barely trade

• A low-volume ETF can still handle large institutional trades

• Liquidity often improves as volatility increases

ETF liquidity scales dynamically.

What Happens During Market Stress?

During stressed markets, something interesting often happens:

• Underlying securities may stop trading efficiently

• ETFs continue to trade

• ETF prices become a price discovery tool

This doesn’t mean ETFs are “broken.”It means they are reflecting real-time market expectations faster than fragmented underlying markets.

From an infrastructure perspective, this is a feature—not a flaw.

Why This Matters for Investors

Understanding this mechanism explains why ETFs:

• Trade with tight spreads

• Handle large inflows and outflows smoothly

• Remain resilient during volatility

• Are trusted by institutional investors

It also explains why ETF design decisions—like in-kind creation, basket construction, and AP participation—matter far more than marketing.

The Bigger Insight

ETF liquidity isn’t about how many people are trading. It’s about how efficiently the system adapts.

Behind every smooth ETF trade is:

• Market infrastructure

• Incentive-aligned participants

• Carefully designed mechanisms

Most investors never see it—and that’s exactly the point.

Final Thought

Working in ETF technology, I’ve seen firsthand how much effort goes into making ETFs feel simple to the end investor.

Liquidity, price alignment, and scalability are not accidental outcomes. They’re engineered.

If my previous blog explained how ETFs are launched, this one explains how they keep working every single day.

And together, they reveal why ETFs have become such a powerful financial structure.