Yue Zhang

I document that 75% of U.S. corporate bond ETFs use more cash in settling creations and redemptions with authorized participants (APs) than the maximum the SEC permits for in-kind classification. Settlement structure is associated with a sharp asymmetry in AP arbitrage. Relative to in-kind ETFs, cash-settled ETFs exhibit weaker arbitrage activity in creation, when ETFs trade at a premium, but arbitrage activity nearly five times stronger in redemption, when ETFs trade at a discount. To interpret these patterns, I develop a model in which settlement structure determines which frictions an arbitrage trade faces: in-kind settlement exposes APs to the cost of holding illiquid bonds, whereas cash settlement requires them to surrender liquid assets. Regulatory capacity determines which APs can respond to these differences. Consistent with the model, the asymmetry is more pronounced when the underlying bonds are more illiquid and among APs with greater regulatory capacity. These findings highlight a regulatory spillover to ETF arbitrage efficiency through financial intermediaries.

We provide the first systematic study of derivative use by exchange-traded funds (ETFs). Over half of ETFs use derivatives, and following a 2019 rule permitting in-kind option transfers, ETF option use increases sharply relative to mutual funds, driven primarily by new product entry. We classify derivative-using ETFs into five economically distinct strategies and find that long-futures ETFs have lower fees than non-derivative users, while synthetic-exposure ETFs are more expensive and perform worse. Although buffer and options-income ETFs have similar exposures and risk-return profiles, they package derivative returns differently and attract distinct investor clienteles: flows into buffer ETFs favor lower tax burdens, whereas flows into options-income ETFs increase with distribution yields despite higher tax burdens. Our findings highlight derivative implementation as an important dimension of ETF product differentiation and investor demand.