Supply and Information Content of Order Book Depth: The Case of Displayed and Hidden Depth

Abstract

A growing number of stock exchanges endogenize the limit order display decision. Nevertheless, the role of hidden depth in the dynamic supply of liquidity remains unclear as empirical research is impeded by the shortage of detailed data on order display instructions. We use a detailed order instruction database from the Copenhagen Stock Exchange to decompose limit order book depth into its displayed and hidden components. First, the role of the two depth classes in the dynamic supply of liquidity is investigated. Specific focus is directed towards the display-ratio. At best quotes a positive relation between changes in hidden depth and our lagged measure of liquidity originated volatility exists. This is not the case for displayed depth. The display-ratios detoriate over the trading day and they are negatively related to lagged liquidity originated volatility. Second, this paper extends the literature on the information content of the limit order book by investigation of the relative information content of hidden and displayed depth imbalances. Interestingly, the information content of hidden depth dominates that of displayed depth. Nevertheless, intraday trading strategies based upon information from both depth classes fail to yield positive returns.

Keywords: Depth imbalance, Order display choice, Limit order book

JEL Classification: G10, G12