Passive exchange-traded fund arbitrage depends on small margins captured by authorized participants when creating or redeeming shares to arbitrage price differences between an ETF and its underlying basket. Liquidity provider fees—the explicit and implicit costs charged by market makers, exchanges, and brokers—directly reduce those margins and therefore the observable returns from arbitrage.
Mechanisms that generate costs
Market microstructure research explains why these fees matter. Albert S. Kyle at MIT Sloan School of Management showed how dealers set spreads to compensate for order-flow risk and inventory costs, so market makers widen spreads when uncertainty rises. Yoram Amihud at New York University Stern School of Business documented that illiquidity raises expected returns because trading costs erode realized gains. In practice, an authorized participant faces exchange fees, crossing the bid-ask spread, market impact when trading large baskets, and any payment to liquidity providers. These components are routinely highlighted by regulators such as the U.S. Securities and Exchange Commission when assessing ETF market structure and the creation/redemption process.
Consequences for arbitrage returns and ETF investors
Higher liquidity provider fees compress arbitrage profits and can make some price divergences persistent rather than immediately arbitraged away. Antti Petajisto at New York University Stern School of Business has shown that arbitrage frictions contribute to tracking error and occasional premiums or discounts relative to NAV. When fees or market impact are large enough, authorized participants may abstain from arbitrage, increasing the likelihood that retail investors bear the cost through wider spreads or stale pricing. This is especially relevant in smaller or emerging markets, where lower market depth and higher transaction costs amplify fee effects and create regional disparities in ETF performance.
Beyond pure returns, these dynamics shape market incentives and resilience. If liquidity providers earn material fees during stressed markets, short-term stability may improve, but long-term costs for passive investors rise. Conversely, tight competition among liquidity providers in deep markets lowers fees, enhancing the efficiency of the arbitrage mechanism and reducing tracking discrepancies.
In sum, fees charged by liquidity providers act as a direct drag on the small margins that passive arbitrage relies upon. Empirical and theoretical work by recognized researchers and regulatory analysis consistently point to the same conclusion: arbitrage returns are sensitive to market microstructure, and investors should consider fee and liquidity environments—both local and global—when assessing ETF efficiency.