The Effect of Hidden Liquidity: Evidence from an Exogenous Shock

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.