Does Off-Exchange Trading Affect Prices and Liquidity on Exchanges?

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policy of the Office of Financial Research (OFR) or U.S. Department of the Treasury.

Nearly half of all U.S. equity trading volume now occurs without a centralized exchange, such as the NYSE or NASDAQ. Instead, many trades are now sent off-exchange where they are executed directly by traders and institutions without going through an exchange. These off-exchange trades frequently appear to receive better prices than trades sent to traditional exchanges, which helps explain why off-exchange trading has become so popular. However, how off-exchange trading affects exchanges’ price discovery and liquidity remains unclear, with recent research suggesting that both may be impacted.

In a new working paper, “There When You (Don’t) Need It: The Reliability of Odd-Lot Liquidity,” Reed Douglas, OFR Researcher, examines how off-exchange trading influences a type of exchange liquidity called odd lots, which are orders for less than 100 shares.

Comparing the prices of off-exchange trades to those on-exchange is difficult. Exchanges have seen increasing levels of hidden liquidity, which include orders sitting on exchanges that are hidden from public view. These orders make comparing prices difficult. While off-exchange prices frequently appear better than publicly observable quotes on exchanges, it is nearly impossible to know the value of hidden orders.

Reed finds that off-exchange trading frequently provides investors with better prices than exchanges could have offered for the most commonly traded stocks. However, off-exchange trading also appears to influence exchange liquidity associated with odd-lot orders. For a short period of time around an off-exchange trade, these hidden odd-lot orders increase in number but decrease in relative value. This change occurs quickly, sometimes only a few milliseconds before an off-exchange trade occurs and typically reverses within half a second. This finding suggests that off-exchange trading quickly and briefly affects exchange liquidity but still appears to provide investors with better prices.

Reed also links the decrease in odd-lot liquidity to increasing order cancellations. These cancellations happen right before a trade, and they appear to remove the most valuable odd-lot orders. This finding suggests that odd lots represent significant liquidity available to investors, but they can disappear right before they are needed to facilitate a trade. So, while odd-lot liquidity is valuable to investors, it has a tendency to disappear when it is needed most.