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Market microstructure is a branch of
finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of f ...
concerned with the details of how exchange occurs in markets. While the theory of market microstructure applies to the exchange of real or financial assets, more evidence is available on the microstructure of
financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial ma ...
due to the availability of transactions data from them. The major thrust of market microstructure research examines the ways in which the working processes of a market affect determinants of transaction costs, prices, quotes, volume, and trading behavior. In the twenty-first century, innovations have allowed an expansion into the study of the impact of market microstructure on the incidence of
market abuse In economics and finance, market abuse may arise in circumstances where investors in a financial market have been unreasonably disadvantaged, directly or indirectly, by others who: * have used information which is not publicly available ( insid ...
, such as
insider trading Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider informati ...
,
market manipulation In economics and finance, market manipulation is a type of market abuse where there is a deliberate attempt to interfere with the free and fair operation of the market; the most blatant of cases involve creating false or misleading appearances ...
and broker-client conflict.


Definition

Maureen O’Hara defines market microstructure as “ ..the study of the process and outcomes of exchanging assets under explicit trading rules. While much of economics abstracts from the mechanics of trading, microstructure literature analyzes how specific trading mechanisms affect the price formation process.” The
National Bureau of Economic Research The National Bureau of Economic Research (NBER) is an American private nonprofit research organization "committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic c ...
has a market microstructure research group that, it says, “is devoted to theoretical, empirical, and experimental research on the economics of securities markets, including the role of information in the price discovery process, the definition, measurement, control, and determinants of liquidity and transactions costs, and their implications for the efficiency, welfare, and regulation of alternative trading mechanisms and market structures.”


Issues

Microstructure deals with issues of market structure and design, price formation and price discovery, transaction and timing cost, volatility, information and disclosure, and market maker and investor behavior.


Market structure and design

This factor focuses on the relationship between price determination and trading rules. In some markets, for instance, assets are traded primarily through dealers who keep an inventory (e.g., new cars), while other markets are facilitated primarily by brokers who act as intermediaries (e.g. housing). One of the important questions in microstructure research is how market structure affects trading costs and whether one structure is more efficient than another. Market microstructure relate the behavior of market participants, whether investors, dealers, investor admins to authority, hence microstructure is a critical factor that affects the investment decision as well as investment exit.


Price formation and discovery

This factor focuses on the process by which the price for an asset is determined. For example, in some markets prices are formed through an auction process (e.g. eBay), in other markets prices are negotiated (e.g., new cars) or simply posted (e.g. local supermarket) and buyers can choose to buy or not.
Mercantilism Mercantilism is an economic policy that is designed to maximize the exports and minimize the imports for an economy. It promotes imperialism, colonialism, tariffs and subsidies on traded goods to achieve that goal. The policy aims to reduce ...
and the later quantity theory of money developed by monetary economists differed in their analysis of price behavior with regard to the stability of output. For mercantilist writers the value of money was the capital it could be exchanged for and it followed that the level was output would therefore be a function of the supply of money available to a country. Under the quantity theory of money the concept of money was more tied to its circulation, therefore output was assumed to be fixed or else, independently variable.


Transaction cost and timing cost

This factor focuses on transaction cost and timing cost and the impact of transaction cost on investment returns and execution methods. Transaction costs include order processing costs, adverse selection costs, inventory holding costs, and monopoly power. Their impact on liquidation of large portfolios has been investigated by Neil Chriss and Robert Almgren and their impact on hedging portfolios has been studied by Tianhui Li and Robert Almgren.


Volatility

This factor focuses on the tendency for prices to fluctuate. Prices may change in response to new information that affects the value of the instrument (i.e. fundamental volatility), or in response to the trading activity of impatient traders and its effect of liquidity (i.e. transitory volatility).


Liquidity

This factor focuses on the ease with which instruments can be converted into cash without affecting its market price. Liquidity is an important measure of a market's efficiency. A variety of elements affect liquidity, including bid-ask spread, tick size, and function of
market makers A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the ''bid–ask spread'', or ''turn.'' The benefit to the firm is that it ...
.


Information and disclosure

This factor focuses on the market information, and more particularly, the availability of market information among market participants, and transparency, and the impact of the information on the behavior of the market participants. Market information can include price, breadth, spread, reference data, trading volumes, liquidity or risk factors, and counterparty asset tracking, etc.


References

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Further reading

* Foucault, Pagano, Roell, ''Market Liquidity: Theory, Evidence, and Policy'', Oxford University Press, 2013, * Jalil, Abdul and Feridun, Mete (2010) Explaining exchange rate movements: An application of the market microstructure approach on the Pakistani foreign exchange market. The Journal of Developing Areas, 44 (1). pp. 255–265. (print), 1548-2278 (on-line) () * Harris, Lawrence, ''Trading & Exchanges: Market Microstructure for Practitioners'', Oxford Press, Oxford, 2003, . * Hasbrouck, Joel, ''Empirical Market Microstructure'', Oxford Press, Oxford, 2007, . * Madhavan, Ananth, 2000, "Market Microstructure: A Survey." Journal of Financial Markets 3, 205-258. * O'Hara, Maureen, ''Market Microstructure Theory'', Blackwell, Oxford, 1995, . * Schwartz, Robert A., Francioni, Reto, "Equity Markets in Action: The Fundamentals of Liquidity, Market Structure & Trading", John Wiley & Sons, 2004, * Schwartz, Robert A., Francioni, Reto, Weber, Bruce W., "The Equity Trader Course", John Wiley & Sons, 2006, . * Stoll, Hans R., "Market Microstructure," in Constantinides, Harris and Stulz (eds.), ''Handbook of the Economics of Finance'', Elsevier, Amsterdam, 2003, . * * Holden, Craig W., Jacobsen, Stacey, Subrahmanyam, Avanidhar, "The Empirical Analysis of Liquidity," 2014, Foundations and Trends 8, No. 4, 1-102 *Aitken, Michael J., Frederick H. de B. Harris, and Shan Ji. “A Worldwide Examination of Exchange Market Quality: Greater Integrity Increases Market Efficiency.” Journal of Business Ethics 132, no. 1 (2015): 147–70. http://www.jstor.org/stable/24703657. *Ranking World Equity Markets on the Basis of Market Efficiency and Integrity (https://ssrn.com/abstract=490462) *High Frequency Trading and End of Day manipulation (https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/289028/12-1055-dr22-high-frequency-trading-and-end-of-day-manipulation.pdf) *High frequency trading–assessing the impact on market efficiency and integrity (https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/289040/12-1061-dr28-high-frequency-trading-impact-on-market-efficiency.pdf) *Melton, H (2017). Market Mechanism Refinement on a Continuous Limit Order Book Venue: A Case Study. SIGecom Exchanges 16(1). (http://www.sigecom.org/exchanges/volume_16/1/MELTON.pdf) *Budish, Eric, Peter Cramton and John Shim.The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response. Quarterly Journal of Economics 130(4), Nov 2015, pp 1547-1621. (http://faculty.chicagobooth.edu/eric.budish/research/HFT-FrequentBatchAuctions.pdf) *''Trading and Exchanges: Market Microstructure for Practitioners'' by Larry Harris


External links

{{Library resources box , by=no , onlinebooks=no , others=no , about=yes , label=Market microstructure * The web site of th
Market Microstructure: Confronting Many Viewpoints
international conference (with links to speakers' presentations). * The website of the Capital Markets Research Cooperative Centre dedicated to optimal market design (https://web.archive.org/web/20141006150618/http://www.cmcrc.com/index.php/) * The Foresight Project on the Future of Computer Trading (https://www.gov.uk/government/collections/future-of-computer-trading) Financial markets Financial economics