Abstracts

We develop a dynamic model of a limit order book market that competes for order flow with off-exchange trading mechanisms. Liquidity suppliers in the limit order book market face a trade-off between the costs and benefits of exposure. Because large exposed orders have the critical mass to elicit order flow from latent investors - in equilibrium - large traders expose their trading intentions. Exposure is mutually beneficent as it generates liquidity externalities and facilitates an efficient coordination of the supply and demand side of liquidity. Thus, it turns out that hidden liquidity can be the source of significant price inefficiencies. We derive a range of testable implications. First, markets with wider spreads and low (opposite-side) depth are 'hidden''; the role of the tick is ambiguous. Second, the use of critically large hidden orders induces price fluctuations and increases transaction costs. Importantly, these trading frictions do not arise from informational asymmetry but rather from the design and structure of trading. Our theory is put to test using both high-frequency order message and hidden liquidity data from NASDAQ.