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.

Mercantilism 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. [3]

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 [4] and their impact on hedging portfolios has been studied by Tianhui Li and Robert Almgren. [5]

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). [6]

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 tick size and function of market makers.

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

Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, which is the study of production, distribution, and consumption of goods and services; the discipline of financial economics bridges the two. Financial activities take place in financial systems at various scopes; thus, the field can be roughly divided into personal, corporate, and public finance.

<span class="mw-page-title-main">Macroeconomics</span> Study of an economy as a whole

Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as output/GDP and national income, unemployment, price indices and inflation, consumption, saving, investment, energy, international trade, and international finance.

<span class="mw-page-title-main">Financial market</span> 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, raw materials and precious metals, which are known in the financial markets as commodities.

<span class="mw-page-title-main">Stock market</span> Place where stocks are traded

A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks, which represent ownership claims on businesses; these may include securities listed on a public stock exchange as well as stock that is only traded privately, such as shares of private companies that are sold to investors through equity crowdfunding platforms. Investments are usually made with an investment strategy in mind.

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 involves the trade-off between the price at which an asset can be sold, and how quickly it can be sold. In a liquid market, the trade-off is mild: one can sell quickly without having to accept a significantly lower price. In a relatively illiquid market, an asset must be discounted in order to sell quickly. Money, or cash, is the most liquid asset because it can be exchanged for goods and services instantly at face value.

Financial economics is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on both sides of a trade". Its concern is thus the interrelation of financial variables, such as share prices, interest rates and exchange rates, as opposed to those concerning the real economy. It has two main areas of focus: asset pricing and corporate finance; the first being the perspective of providers of capital, i.e. investors, and the second of users of capital. It thus provides the theoretical underpinning for much of finance.

This aims to be a complete article list of economics topics:

In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. The idea that transactions form the basis of economic thinking was introduced by the institutional economist John R. Commons in 1931, and Oliver E. Williamson's Transaction Cost Economics article, published in 2008, popularized the concept of transaction costs. Douglass C. North argues that institutions, understood as the set of rules in a society, are key in the determination of transaction costs. In this sense, institutions that facilitate low transaction costs, boost economic growth.

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.

<span class="mw-page-title-main">Bid–ask spread</span> Financial markets concept

The bid–ask spread is the difference between the prices quoted for an immediate sale (ask) and an immediate purchase (bid) for stocks, futures contracts, options, or currency pairs in some auction scenario. 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.

The theory of the firm consists of a number of economic theories that explain and predict the nature of the firm, company, or corporation, including its existence, behaviour, structure, and relationship to the market. Firms are key drivers in economics, providing goods and services in return for monetary payments and rewards. Organisational structure, incentives, employee productivity, and information all influence the successful operation of a firm in the economy and within itself. As such major economic theories such as transaction cost theory, managerial economics and behavioural theory of the firm will allow for an in-depth analysis on various firm and management types.

Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.

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 attempts to leverage the speed and computational resources of computers relative to human traders. In the twenty-first century, algorithmic trading has been gaining traction with both retail and institutional traders. A study in 2019 showed that around 92% of trading in the Forex market was performed by trading algorithms rather than humans.

The goals of experimental finance are to understand human and market behavior in settings relevant to finance. Experiments are synthetic economic environments created by researchers specifically to answer research questions. This might involve, for example, establishing different market settings and environments to observe experimentally and analyze agents' behavior and the resulting characteristics of trading flows, information diffusion and aggregation, price setting mechanism and returns processes.

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. She has been awarded honorary doctorates from three European universities.

The following outline is provided as an overview of and topical guide to finance:

The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a neoclassical economics academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936). It was formulated most notably by John Hicks (1937), Franco Modigliani (1944), and Paul Samuelson (1948), who dominated economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 60s, and 70s.

In economics and finance, the price discovery process is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers.

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.

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. ↑ Green 1992, p. 51.
  4. ↑ R.Almgren and N.Chriss, "Optimal execution of portfolio transactions" J. Risk, 3 (Winter 2000/2001) pp.5–39
  5. ↑ Robert Almgren; Tianhui Li (2016). "Option Hedging with Smooth Market Impact". Market Microstructure and Liquidity. 2: 1650002. doi:10.1142/S2382626616500027.
  6. ↑ Harris, Larry, 1956- (2003). Trading and exchanges : market microstructure for practitioners. Oxford: Oxford University Press. ISBN   0-19-514470-8. OCLC   49415674.{{cite book}}: CS1 maint: multiple names: authors list (link) CS1 maint: numeric names: authors list (link)

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