Limit order book transparency, execution risk, and market liquidity

This study provides new evidence regarding the effect of limit order book disclosure on trading behavior. The natural experiment affected by the Sydney Futures Exchange in January 2001, when it increased limit order book disclosure from depth at the best bid and ask prices to depth at the three best bid and ask prices is examined. Evidence was found consistent with a change in trading behavior coinciding with the increase in pre-trade transparency. Consistent with predictions of a theoretical model based on execution risk, a statistically significant decline in depth was found at the best quotes. There is little evidence of an increase in bid-ask spreads. Further, the proportion of market orders exceeding depth at the best quotes increases in a transparent limit order book, reflecting a reduction in execution risk. The study concludes that in a transparent market, limit order traders charge market order traders a higher premium for execution certainty by withdrawing depth from the best quotes, but not by increasing bid-ask spreads.