Abstract
We develop a model of an order-driven exchange competing for order flow with off-exchange trading mechanisms. Large investors can trade in either the primary market or the off-exchange market and induce liquidity externalities. Liquidity suppliers in the primary market face a trade-off between the costs and benefits of order exposure. If they display their trading intentions, they can benefit from elicited order flow from latent investors. In an equilibrium analysis, we show that hiding orders can cause adverse effects for the individual and the overall market. In fact, the resulting miscoordination between liquidity supply and demand causes price reactions and harms price efficiency. Using a unique dataset of hidden orders in NASDAQ trading and an econometric high-frequency analysis, we find strong empirical support for our theoretical predictions. We find abnormal reactions in prices and order flow after periods of high one-sided hidden order volume.
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