How Does the Introduction of Hidden Orders Affect Limit Order Markets?

Abstract

Hidden orders are widely used in major exchanges. This paper studies how hidden orders affect markets by introducing these orders to the limit order market model in Foucault et al. (2005). We investigate the equilibrium outcomes in an infinite-time horizon model with multiple price levels and unknown hidden order queues by extending the algorithms in Pakes and McGuire (2001). The model suggests that the introduction of hidden orders (including the hidden limit orders and the midpoint peg orders) increases the profit of patient traders, slightly worsens impatient traders' average executed market prices, mitigates price impact by reducing both the effective spread and the Amihud illiquidity measure, and decreases the mid-quote volatility.

Keywords: Hidden orders, limit order markets, market liquidity

JEL Classification: C7, G14, G19