Liquidity: What you see is what you get?

Competition between electronic limit order books improves the overall liquidity of equity markets in most studies. However, my model shows that liquidity oered on the limit order books combined may strongly overestimate the actual liquidity avail- able to investors. The excess is caused by high-frequency traders operating as market makers, who may duplicate their limit order schedules on several venues to increase their execution probabilities. Then, after a trade on one venue they will quickly cancel outstanding limit orders on others. The magnitude of the cancellations depends on the fraction of investors that may access several venues simultaneously, i.e., who use Smart Order Routing Technology (SORT). The reason is that market makers incur higher adverse selection costs when the investor trades at a competing venue …rst. Consequently, a higher fraction of SORT investors reduces the incentives of market makers to place duplicate limit orders. The empirical results con…rm the main pre- diction of the model, as trades on the most active venues are followed by cancellations of limit orders on competing venues of more than 53% of the trade size.