The Effect of Hidden Liquidity: Evidence from an Exogenous Shock

60 Pages Posted: 11 Feb 2021 Last revised: 24 Apr 2021

See all articles by Amy K. Edwards

Amy K. Edwards

Securities and Exchange Commission (SEC)

Paul Hughes

Securities and Exchange Commission

John Ritter

Securities and Exchange Commission (SEC)

Patti Vegella

Securities and Exchange Commission

Hao Zhang

Rochester Institute of Technology (RIT) - Saunders College of Business

Date Written: March 1, 2021

Abstract

While existing studies find mixed results on the effect of hidden liquidity, this study exploits the Tick Size Pilot (“the Pilot”) as a quasi-natural experiment and uses instrumental-variable regression analyses to examine 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 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 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

Edwards, Amy K. and Hughes, Paul and Ritter, John and Vegella, Patti and Zhang, Hao, The Effect of Hidden Liquidity: Evidence from an Exogenous Shock (March 1, 2021). Available at SSRN: https://ssrn.com/abstract=3766512. or http://dx.doi.org/10.2139/ssrn.3766512

Amy K. Edwards

Securities and Exchange Commission (SEC) ( email )

100 F St NE
Washington, DC 20549-1105
United States
202-551-6663 (Phone)

Paul Hughes

Securities and Exchange Commission ( email )

100 F Street NE
Washington, DC 20549
United States

John Ritter (Contact Author)

Securities and Exchange Commission (SEC) ( email )

450 Fifth Street, NW
Washington, DC 20549-1105
United States

Patti Vegella

Securities and Exchange Commission ( email )

100 F Street, NE
Washington, DC 20549
United States

Hao Zhang

Rochester Institute of Technology (RIT) - Saunders College of Business ( email )

105 Lomb Memorial Dr.
Rochester, NY 14623
United States

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