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Does Hidden Liquidity Harm Price Efficiency?

57 Pages Posted: 4 Aug 2013 Last revised: 30 Aug 2014

Gökhan Cebiroglu

University of Vienna, Faculty of Business and Economics

Nikolaus Hautsch

University of Vienna - Department of Statistics and Operations Research; Center for Financial Studies (CFS)

Ulrich Horst

Humboldt University of Berlin

Date Written: August 26, 2014

Abstract

We develop a model of an order-driven exchange competing for order flow with off-exchange trading mechanisms. Large investors can trade in either the primary market or the off-exchange market and induce liquidity externalities. Liquidity suppliers in the primary market face a trade-off between the costs and benefits of order exposure. If they display their trading intentions, they can benefit from elicited order flow from latent investors. In an equilibrium analysis, we show that hiding orders can cause adverse effects for the individual and the overall market. In fact, the resulting miscoordination between liquidity supply and demand causes price reactions and harms price efficiency. Using a unique dataset of hidden orders in NASDAQ trading and an econometric high-frequency analysis, we find strong empirical support for our theoretical predictions. We find abnormal reactions in prices and order flow after periods of high one-sided hidden order volume.

Keywords: Liquidity Coordination, Signalling, Pre-announcements, Hidden Liquidity, Limit Order Books, Liquidity Externalities

JEL Classification: G02, G10, G23

Suggested Citation

Cebiroglu, Gökhan and Hautsch, Nikolaus and Horst, Ulrich, Does Hidden Liquidity Harm Price Efficiency? (August 26, 2014). Available at SSRN: https://ssrn.com/abstract=2305171 or http://dx.doi.org/10.2139/ssrn.2305171

Gökhan Cebiroglu (Contact Author)

University of Vienna, Faculty of Business and Economics ( email )

Oskar-Morgenstern-Platz 1
Vienna, 1090
Austria
+43-1-4277-38682 (Phone)

Nikolaus Hautsch

University of Vienna - Department of Statistics and Operations Research ( email )

Oskar-Morgenstern-Platz 1
Vienna, A-1090
Austria

Center for Financial Studies (CFS) ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Ulrich Horst

Humboldt University of Berlin ( email )

Unter den Linden 6
Berlin, Berlin 10099
Germany

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