Order Exposure and Liquidity Coordination: Does Hidden Liquidity Harm Price Efficiency?
60 Pages Posted: 4 Oct 2014
Date Written: September 18, 2014
We develop a model of an order-driven exchange competing for order flow with off-exchange trading mechanisms. Liquidity suppliers face a trade-off between benefits and costs of order exposure. If they display trading intentions, they attract additional trade demand. We show, in equilibrium, hiding trade intentions can induce mis-coordination between liquidity supply and demand, generate excess price fluctuations and harm price efficiency. Econometric high-frequency analysis based on unique data on hidden orders from NASDAQ reveals strong empirical support for these predictions: We find abnormal reactions in prices and order flow after periods of high excess-supply of hidden liquidity.
Keywords: liquidity externalities, order flow, trade signaling, limit order book
JEL Classification: G02, G10, G23
Suggested Citation: Suggested Citation