Market microstructure

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Market microstructure is a branch of finance 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 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, such as insider trading, market manipulation and broker-client conflict.

Contents

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.” [1]

The National Bureau of Economic Research 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.” [2]

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.

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 [3] and their impact on hedging portfolios has been studied by Tianhui Li and Robert Almgren. [4]

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). [5]

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.

Related Research Articles

Financial market generic term for all markets in which trading takes place with capital

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, and precious metals.

Market liquidity ability of an asset to be bought or sold on the market without causing a drastic change in the assets price

In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity is about how big the trade-off is between the speed of the sale and the price it can be sold for. In a liquid market, the trade-off is mild: selling quickly will not reduce the price much. In a relatively illiquid market, selling it quickly will require cutting its price significantly enough to generate interest.

In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market.

In financial markets, market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e., upward when buying and downward when selling. It is closely related to market liquidity; in many cases "liquidity" and "market impact" are synonymous.

Market maker financial markets term

A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid–ask spread, or turn. The U.S. Securities and Exchange Commission defines a "market maker" as a firm that stands ready to buy and sell stock on a regular and continuous basis at a publicly quoted price.

The foreign exchange market is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market.

Bid–ask spread

The bid–ask spread, is the difference between the prices quoted for an immediate sale (offer) and an immediate purchase (bid) for stocks, futures contracts, options, or currency pairs. The size of the bid–ask spread in a security is one measure of the liquidity of the market and of the size of the transaction cost. If the spread is 0 then it is a frictionless asset.

Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.

Covered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on the interest rate differential between two countries by using a forward contract to cover exchange rate risk. Using forward contracts enables arbitrageurs such as individual investors or banks to make use of the forward premium to earn a riskless profit from discrepancies between two countries' interest rates. The opportunity to earn riskless profits arises from the reality that the interest rate parity condition does not constantly hold. When spot and forward exchange rate markets are not in a state of equilibrium, investors will no longer be indifferent among the available interest rates in two countries and will invest in whichever currency offers a higher rate of return. Economists have discovered various factors which affect the occurrence of deviations from covered interest rate parity and the fleeting nature of covered interest arbitrage opportunities, such as differing characteristics of assets, varying frequencies of time series data, and the transaction costs associated with arbitrage trading strategies.

Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading was developed to make use of the speed and data processing advantages that computers have over human traders. Popular "algos" include Percentage of Volume, Pegged, VWAP, TWAP, Implementation shortfall and Target close. In the twenty-first century, algorithmic trading has been gaining traction with both retail and institutional traders. It is widely used by investment banks, pension funds, mutual funds, and hedge funds that may need to spread out the execution of a larger order or perform trades too fast for human traders to react to. A study in 2016 showed that over 80% of trading in the FOREX market was performed by trading algorithms rather than humans.

Maureen Patricia O'Hara is an American financial economist. O'Hara is the Robert W. Purcell Professor of Management, a professor of finance, and Acting Director in Graduate Studies at the Samuel Curtis Johnson Graduate School of Management at Cornell University. She has won numerous awards and grants for her research, served on numerous boards, served as an editor for numerous finance journals, and chaired the dissertations of numerous students. In addition, she is well known as the author of Market Microstructure Theory. She was the first female president of the American Finance Association.

Dark pool

In finance, a dark pool is a private forum for trading securities, derivatives, and other financial instruments. Liquidity on these markets is called dark pool liquidity. The bulk of dark pool trades represent large trades by financial institutions that are offered away from public exchanges like the New York Stock Exchange and the NASDAQ, so that such trades remain confidential and outside the purview of the general investing public. The fragmentation of electronic trading platforms has allowed dark pools to be created, and they are normally accessed through crossing networks or directly among market participants via private contractual arrangements. Generally dark pools are not available to the public, but in some cases they may be accessed indirectly by retail investors and traders via retail brokers.

The price discovery process is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers. The futures and options market serve all important functions of price discovery. The individuals with better information and judgement participate in these markets to take advantage of such information. When some new information arrives, perhaps some good news about the economy, for instance, the actions of speculators quickly feed their information into the derivatives market causing changes in price of derivatives. These markets are usually the first ones to react as the transaction cost is much lower in these markets than in the spot market. Therefore these markets indicate what is likely to happen and thus assist in better price discovery.

High-frequency trading (HFT) is a type of algorithmic financial trading characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. While there is no single definition of HFT, among its key attributes are highly sophisticated algorithms, co-location, and very short-term investment horizons. HFT can be viewed as a primary form of algorithmic trading in finance. Specifically, it is the use of sophisticated technological tools and computer algorithms to rapidly trade securities. HFT uses proprietary trading strategies carried out by computers to move in and out of positions in seconds or fractions of a second.

David Alan Easley is an American economist. Easley is the Henry Scarborough Professor of Social Science and is a Professor of Information Science at Cornell University.

Order matching system

An order matching system or simply matching system is an electronic system that matches buy and sell orders for a stock market, commodity market or other financial exchange. The order matching system is the core of all electronic exchanges and are used to execute orders from participants in the exchange.

LMAX Group

LMAX Group is a global financial technology company which operates multiple institutional execution venues for electronic foreign exchange (FX) and crypto currency trading.

Robert F. Almgren is an applied mathematician, academic, and businessman focused on market microstructure and order execution. He is the son of renowned Princeton mathematician Frederick J. Almgren, Jr. With Neil Chriss, he wrote a paper "Optimal execution of portfolio transactions", which Institutional Investor said "helped lay the groundwork for arrival-price algorithms being developed on Wall Street." He is a cofounder of Quantitative Brokers and its Head of Research, and a visiting professor in Operations Research and Financial Engineering at Princeton University.

Cross border listings is the practice of listing a company's common shares on a different exchange than its primary stock exchange.

Transaction cost analysis (TCA), as used by institutional investors, is defined by the Financial Times as "the study of trade prices to determine whether the trades were arranged at favourable prices – low prices for purchases and high prices for sales". It is often split into two parts – pre-trade and post-trade. Recent regulations, such as the European Markets in Financial Instruments Directive, have required institutions to achieve best execution.

References

  1. O'Hara, Maureen, Market Microstructure Theory, Blackwell, Oxford, 1995, ISBN   1-55786-443-8, p.1.
  2. NBER Working Group Descriptions Archived 2008-07-22 at the Wayback Machine
  3. R.Almgren and N.Chriss, "Optimal execution of portfolio transactions" J. Risk, 3 (Winter 2000/2001) pp.5–39
  4. Robert Almgren; Tianhui Li (2016). "Option Hedging with Smooth Market Impact". Market Microstructure and Liquidity. 2: 1650002. doi:10.1142/S2382626616500027.
  5. Harris, Larry, 1956- (2003). Trading and exchanges : market microstructure for practitioners. Oxford: Oxford University Press. ISBN   0-19-514470-8. OCLC   49415674.CS1 maint: multiple names: authors list (link)

Further reading