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.” TheIssues
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.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 ofInformation 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
*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 HarrisExternal links
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