The Effect of Hidden Liquidity: Evidence from an Exogenous Shock
66 Pages Posted: 11 Feb 2021
Date Written: January 7, 2021
While existing studies find mixed results on the effect of hidden liquidity, this study uses the Tick Size Pilot (“the Pilot”) as an instrument to study how hidden liquidity, both on and off-exchange, affect the informativeness of quotations. We document that an increase in tick size results in a reduction in pre-trade transparency, but with opposing effects on on- and off-exchange hidden liquidity. We find that an increase in either hidden liquidity reduces price efficiency, the contribution of quotes to price discovery, and the ability to manage the order execution risk and cost of exchange order submission. In addition, an increase in either hidden liquidity reduces the ability to manage transaction costs off-exchange. These results hold for both on- and off-exchange hidden liquidity. However, several results differ when pre-trade transparency is measured using trade-based measures of hidden liquidity rather than order-based measures.
Keywords: Hidden Liquidity, Off-Exchange Routing Pre-Trade Transparency, Price Efficiency, Price Discovery, Information Shares, Execution Risk, Execution Cost, Tick Size
JEL Classification: G14, G18
Suggested Citation: Suggested Citation