Factors in the Illiquidity of Thinly Traded Securities

ABSTRACT This paper reexamines foundational liquidity factors in light of modern market dynamics, focusing on liquidity across thinly versus actively traded securities. Specifically, we explore whether the liquidity gap identified by the SEC is a byproduct of trading volume or a more complex response to evolving market factors such as market fragmentation, adverse selection, inventory costs, and competition. We find that modern liquidity components have asymmetric effects, with thinly traded securities facing significantly higher execution costs, latency, and temporal fragmentation compared to actively traded stocks. Market fragmentation, in particular, exacerbates these inefficiencies for low‐activity stocks, as liquidity becomes more fragmented and execution times increase. Furthermore, we show that competition among exchanges benefits high‐activity stocks but has a detrimental impact on the execution quality of low‐activity stocks, leading to larger quoted spreads and slower executions. Our findings suggest that liquidity disparities are not simply a function of trading volume but also reflect the impact of modern market dynamics. This has important implications for market design and regulatory policy, particularly for ensuring that thinly traded stocks are not unduly disadvantaged by fragmentation‐induced inefficiencies.