Inside Volume and Liquidity

We decompose volume into two components: trades that consist of matches between investor buyers and investor sellers; and, trades where a liquidity provider takes the other side of either an investor sell or buy. We refer to the latter type of trade as inside volume. Our identification assumption is that a trade at time t involving a liquidity provider is reversed shortly after time t, leading to predictable short-run behavior in both prices and volume. Our results provide a gauge as to the component of volume that is driven by frictional financial markets, as opposed to changes in investors' desired portfolio allocations.