Market microstructure

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 affects determinants of transaction costs, prices, quotes, volume, and trading behavior.

Definition

Maureen O’Hara defines market microstructure as “the study of the process and outcomes of exchanging assets under a specific set of rules. While much of economics abstracts from the mechanics of trading, microstructure theory focuses on 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, 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 through dealers who keep an inventory (e.g., new cars), while other markets are dominated 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.

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.

Information and disclosure

This factor focuses on the market information and transparency and the impact of the information on the behavior of the market participants.

References

1. ^ O'Hara, Maureen, Market Microstructure Theory, Blackwell, Oxford, 1995, ISBN 1-55786-443-8.
2. ^ NBER Working Group Descriptions

See Also

• Harris, Lawrence, Trading & Exchanges, Market Microstructure for Practitioners, Oxford Press, Oxford, 2003, ISBN 0-19-514470-8.
• Hasbrouck, Joel, Empirical Market Microstructure, Oxford Press, Oxford, 2007, ISBN 0-19-530164-1.
• Madhavan, Ananth, 2000, "Market Microstructure: A Survey." Journal of Financial Markets 3, 205-258.
• O'Hara, Maureen, Market Microstructure Theory, Blackwell, Oxford, 1995, ISBN 1-55786-443-8.
• Stoll, Hans R., "Market Microstructure," in Constantinides, Harris and Stulz (eds.), Handbook of the Economics of Finance, Elsevier, Amsterdam, 2003, ISBN 0-44-451363-9.