On the Hidden Side of Liquidity

Abstract

An important number of stock exchanges allow market participants to enter limit orders without revealing the full size. However, there is a lot of controversy over the use and consequences of hidden orders, since they embrace a complex interaction between order exposure risk, market liquidity and transparency. Our study focuses on the motives of submitting undisclosed limit orders to trade as well as on the market response when the presence of these orders is publicly revealed. Using data from the Spanish Stock Exchange, we find that hidden orders emerge in periods of intense trading activity and extremely high liquidity. Our results find no evidence that the undisclosed volume is used as a defensive strategy against parasitic traders. On the contrary, we provide support to the notion that liquidity suppliers use hidden orders to mitigate adverse selection costs. We also report that hidden orders temporally increase the aggressiveness of traders when they are revealed to the marketplace but, as opposed to the widespread opinion among practitioners, they have no relevant price impact.