True ETF Liquidity: Understanding the Distinction Between On-Screen and Underlying Liquidity

When most investors think about liquidity in ETFs, their eyes naturally drift to the order book that they see displayed when they enter a ticker symbol. The bid-ask spread, the depth of visible orders, and the volume figures get prominently displayed in trading platforms and help create an intuitive sense of liquidity. Yet this on-screen perspective can be deceptively narrow. True ETF liquidity extends far beyond what appears in the visible order book, and understanding this distinction is crucial for anyone buying or selling ETFs.

Defining ETF Liquidity

At its core, liquidity refers to the ease and speed with which an asset can be bought or sold without significantly affecting its price. For ETFs, this definition becomes more nuanced than it might be for individual stocks. ETF shares trade on exchanges like regular equities, but they possess a unique structural advantage that fundamentally alters how their liquidity truly functions.

An ETF that appears to have low on-screen liquidity —a sparse order book with wide spreads—may still have robust actual liquidity through mechanisms invisible on the standard trading screen. This paradox confuses many investors who conflate visible market depth with true tradability. The core understanding is this: An ETF is as liquid as its underlying holdings.

The Create/Redeem Mechanism: The Core of Real Liquidity

The key to understanding why on-screen liquidity matters less than most assume lies in the authorized participant system and the create/redeem mechanism. Think of it like this: imagine you go to a grocery store wanting to buy five chocolate cakes, but you only see one on the shelf in the bakery section. You might think, "Oh no, I can't get the five cakes I want to purchase, they only have one available." But what you don't realize is that the store's bakers (in the case of an ETF, the authorized participants or market makers) can create new cakes on demand. They have direct access to all of the underlying ingredients in the store require to make an extra cake, and they can make essentially unlimited cakes whenever needed. In theory, despite only displaying one cake, they could produce a thousand, if they had access to all of the ingredients required to make that many cakes.

That's exactly how ETF liquidity works. An ETF share showing limited on-screen availability isn't usually that supply-constrained because authorized participants possess the unique ability to create new ETFs directly with the ETF asset manager by delivering the underlying basket of securities. Conversely, the market makers can redeem (or break apart) shares of the ETF by exchanging them for the underlying holdings.

A small-cap or specialized ETF might show only a few thousand shares in visible orders at any given moment, just like that single cake on the bakery shelf. Yet an investor seeking to purchase or liquidate a million-share position could potentially execute that trade at a price very close to the net asset value, thanks to the ability of authorized participants to create or redeem shares. In this example, an on-screen order book proved irrelevant to the actual transaction, just as the single visible cake is irrelevant to whether you can actually obtain five cakes.

Market Maker Competition And Tightening Spreads

Beyond the create/redeem mechanism, traditional market makers also contribute to ETF liquidity in ways that extend beyond visible order depth. The natural arbitrage between a bid/ask spread and any deviation from net asset value means that market makers are incentivized to offer tight spreads and maintain continuous two-sided markets. This competitive dynamic operates even when the visible order book appears sparse.

A market maker will often maintain liquidity by standing ready to buy or sell at prices competitive relative to the fund's net asset value, knowing they can hedge their position by transacting in the underlying securities or by engaging in creation or redemption orders. They do not need to rely on offsetting buy and sell orders within the market; they can facilitate trading and manage their risk through other mechanisms. This is fundamentally different from, say, a thinly traded stock where market makers depend on eventual offsetting orders from other participants.

The result is that even ETFs with seemingly illiquid appearances often trade at tight spreads in practice. An experienced trader submitting a large order to a lightly traded ETF might receive better execution than the on-screen order book would suggest, because the liquidity provider can immediately hedge that exposure through the underlying market or through the create/redeem process.

Multiple Avenues For Additional Liquidity

The underlying market liquidity is much more relevant to the tradability of an ETF than the on-screen, visible secondary market. This can appear to be a paradox if someone is learning about ETFs. To give a straightforward example, an ETF tracking a broad index of US Treasuries could appear to have minimal order flow and very few trades on the tape. The reality is that the genuine liquidity of this ETF is excellent because the underlying securities, US Treasury Bills, trade in deep, highly liquid markets. An authorized participant can instantly execute large secondary-market trades in these underlying securities if needed and without moving the price of the ETF.

Authorized participants can also tap into the use of liquid proxies. In the case of trading an Emerging Markets equity ETF, they don’t always need to trade every share of every underlying company explicitly. Instead, APs can use liquid proxies, other instruments such as emerging market index futures, currency forwards, or highly liquid mega-cap emerging market stocks that move in tandem with the fund's holdings. By hedging their exposure through these more liquid instruments, APs can create and redeem ETF shares efficiently even when the full basket of underlying securities might be cumbersome to trade.

This proxy-hedging capability also dramatically expands the underlying liquidity of ETFs, even if it is not necessarily visible to the untrained eye. In this example of an Emerging Markets equity ETF, an AP facing a large redemption doesn't need to unwind positions across dozens of illiquid emerging market stocks in various countries. Instead, they can use futures or other securities to hedge their market exposure while they gradually liquidate the underlying holdings over time, or they can simply match the fund's returns using the liquid proxies themselves. Authorized Participants have a lot of different tools in their toolbox to facilitate ETF transactions at or close to the ETF’s net asset value, regardless of whether or not there is visible demand for the ETF in the secondary market.

Why On-Screen Metrics Can Mislead

The prevalence of liquidity measurement tools that focus exclusively on bid-ask spreads and order depth can create a misleading narrative around ETF liquidity. These metrics capture only a snapshot of one moment in time and reflect only the specific orders visible on one exchange. They ignore the continuous create/redeem capability and the numerous liquidity sources operating behind the scenes.

An investor comparing ETFs based solely on displayed spreads might incorrectly conclude that a smaller ETF with a 3c spread is less liquid than a similar ETF with a 1c spread. In reality, the difference in actual tradability might be negligible if the ETF benefits from active authorized participant involvement and underlying market liquidity.

Practical Implications For Investors

This distinction between on-screen and true liquidity carries real consequences for investment decisions and portfolio construction. An investor with a significant position to establish or liquidate in a specialized ETF should not be deterred by a seemingly sparse order book or trade history. Instead, they should consider factors like the quality and liquidity of the underlying holdings, the presence of active market makers, and the history and reputation of the asset manager.

Large institutional investors, in particular, benefit from understanding this nuance. Rather than using visible spreads as the primary liquidity gauge, they evaluate actual execution through broker networks and direct relationships with market makers, knowing that these sources of liquidity extend far beyond what appears on screen.

Conclusion

ETF liquidity represents a more complex phenomenon for investors to understand. While visible order books and spreads provide useful context, they capture only a fraction of the available liquidity sources. The create/redeem mechanism, the underlying securities market's depth, the incentives driving trading participation and dynamic market making activity all work together to collectively ensure that even ETFs with small on-screen trading volumes can still access excellent liquidity in real world transactions. Understanding this distinction allows investors to make more informed decisions around ETF trading, and should ultimately reduce unnecessary trading costs and improve portfolio outcomes.

Valerie Grimba serves as Director, Global ETF Strategy at RBC Capital Markets. In this role, she is responsible for providing solutions to help RBC’s institutional clients better understand and implement ETF strategies. She also bridges the gap between clients and ETF trade execution; helping to facilitate global ETF trading and market making for ETF products. Valerie has over 15 years of trading experience and several global market accreditations including the ability to trade on international equity exchanges including Canada, the U.S., Australia and New Zealand.

Disclaimer:

This communication has been prepared by a member of the ETF Market Making Desk of RBC Capital Markets for institutional clients and for your information. Unless otherwise specified, the views expressed in this electronic communication are the author’s and may differ from the views of RBC Capital Markets’ Research Department and from the views of others within RBC Capital Markets. The information in the body of this communication is intended to provide trading and market structure commentary and is not intended to provide a sufficient basis for an investment decision and should not be considered a Research Report. Complete research notes and reports, including important conflicts disclosures, are available at www.rbcinsight.com. You should assume that trading desks at RBC Capital Markets or its affiliates makes markets and/or hold positions, may have conducted underwriting or other investment banking work in any of the securities referenced herein. This electronic communication is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product, or service. The information contained in the body of this communication is derived from market data sources of the ETF Market Making Desk of RBC Capital Markets and is deemed to be reliable but no representation or warranty, express or implied, is made by Royal Bank of Canada, RBC Capital Markets, its affiliates or any other person as to its accuracy, completeness or correctness. RBC Capital Markets does not undertake any obligation to update this material. To the full extent permitted by law neither RBC Capital Markets Dominion Securities Inc, RBC Capital Markets LLC, RBC Europe Limited, nor any of its affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of the information contained herein. This e-mail (including any attachments) is intended only for the direct recipients. Any distributing, copying or other use of this e-mail or the information it contains, by other than an intended recipient, is not sanctioned and is prohibited. RBC Capital Markets is the global brand name for the capital markets business of Royal Bank of Canada and its affiliates. United States: This communication has been approved by RBC Capital Markets, LLC (member FINRA, NYSE, SIPC), which is a U.S. registered broker-dealer and which accepts responsibility for this communication and its dissemination in the United States. Any U.S. recipient of this communication that is not a registered broker-dealer or a bank acting in a broker or dealer capacity and that wishes further information regarding, or to effect any transaction in, any of the securities discussed in this communication, should contact and place orders with RBC Capital Markets, LLC. IMPORTANT DISCLOSURE: THIS COMMUNICATION HAS BEEN GENERATED BY AN EMPLOYEE OF RBCCM AND IS BEING CONVEYED TO YOU AS A SOLICITATION (FOR PURPOSES OF 17 CFR ßß1.71(a)-(c) AND 23.605) FOR ENTERING INTO A DERIVATIVES TRANSACTION. This communication is not a research report or a product of RBCCM's Research Department. Canada: RBC Dominion Securities Inc. (member IIROC and CIPF). United Kingdom: This publication has been approved by RBC Europe Limited, which is authorized by the Prudential Regulation Authority (“PRA”) and regulated by the Financial Conduct Authority and PRA. Hong Kong: RBC Capital Markets (Hong Kong) Limited and Royal Bank of Canada, Hong Kong Branch (both entities regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission (“SFC”). Financial Services provided to Australia: Financial services may be provided in Australia in accordance with applicable law. Financial services provided by the Royal Bank of Canada, Hong Kong Branch are provided pursuant to the Royal Bank of Canada's Australian Financial Services Licence (“AFSL”) (No. 246521). RBC Capital Markets (Hong Kong) Limited is exempt from the requirement to hold an AFSL under the Corporations Act 2001 with respect to the provision of such financial services. RBC Capital Markets (Hong Kong) Limited is regulated by the Hong Kong Monetary Authority and the SFC under the laws of Hong Kong, which differ from Australian laws. Australia: Royal Bank of Canada, Sydney Branch (regulated by the Australian Securities & Investments Commission and the Australian Prudential Regulation Authority; AFSL 246521; ABILLION 86 076 940 880). This document is distributed only to persons who satisfy the definition of wholesale client for the purposes of the Corporations Act 2001 and not intended for distribution to retail clients. Japan: Unless otherwise exempted by Japanese law, this document is distributed in Japan by or through RBC Capital Markets (Japan) Ltd. Tokyo Branch, a registered type one financial instruments firm and/or Royal Bank of Canada, Tokyo Branch, a licensed foreign bank, as the case may be. Singapore: Royal Bank of Canada, Singapore Branch (regulated by the Monetary Authority of Singapore).

The Royal Bank of Canada ("RBC") through its wholly owned subsidiary RBC Dominion Securities Inc. ("RBCDS"), along with various "buy-side" organizations and other market participants, is a founding shareholder in Aequitas, the parent company of Aequitas Neo Exchange. As a founding shareholder of Aequitas, a private company, RBCDS will have representation on the Aequitas Board of Directors. As a member (participant) of Aequitas Neo Exchange RBCDS may, consistent with best execution and other applicable regulatory requirements, route your orders to the Aequitas Neo Exchange in the normal course. RBCDS may also act as a designated market maker on Aequitas Neo Exchange. Additionally, as a full-service global financial firm, in the normal course of its operations RBCDS may provide market making services in respect of one or more ETF securities referred to herein.

® Registered trademark of Royal Bank of Canada. Used under license.