Price Discovery Without Trading: Evidence from Limit Orders

Abstract

Adverse selection in financial markets is traditionally measured by the correlation between the direction of market order trading and price movements. We show this relationship has weakened dramatically with limit orders playing a larger role in price discovery and with high-frequency traders’ (HFTs) limit orders playing the largest role. HFTs are responsible for 60-80% of price discovery, primarily through their limit orders. HFTs’ limit orders have 50% larger price impact than non-HFTs’ limit orders, and HFTs submit limit orders 50% more frequently. HFTs react more to activity by non-HFTs than the reverse. HFTs react more to messages both within and across stock exchanges.