Financial Intermediaries and Comovement in Market Efficiency: The Case of ETFs

We propose that intermediaries' capital constraints cause comovement in the degree of pricingefficiency for assets they manage. We use a simple model to demonstrate this idea for ETFs andtheir lead market makers (LMMs). Empirically, we show significant comovement in premia forETFs with the same LMM, which exceeds that in ETFs without a common LMM. The comovementis not due to style effects, and is stronger for more capital-constrained LMMs. Around the debt market disruptions of COVID-19, the non-fixed-income ETFs of LMMs more active in fixed incomeexperience greater premia. Overall, intermediaries’ constraints indeed influence comovements inmarket efficiency.