Market Microstructure 2: An Overview

What is market microstructure?

Market microstructure is about the fundamental forces involved in market exchange. Economics and finance tends to abstract itself away from the underlying details of trading and exchange, but market microstructure puts these details at the center of the analysis, and investigates how these change the basic supply and demand interactions.

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In short, market microstructure aims to understand the foundations of markets. It is concerned with (1) market structure and design, (2) price formation and discovery, and (3) liquidity and transaction costs. While a disperate subject ("market microstructure theory may appear an amorphous collection of models, with little in common but subject matter", O'Hara p.2), there is fairly clear agreement on these subject areas:

  • The NBER working group on Market Microstructure definition identifies these subjects: "...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."
  • Maureen O'Hara wrote the foundational monograph on the subject ("Market Microstructure Theory"), in which she 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." (p.1)
  • Nikolaus Hautsche identifies the central topics in market microstructure theory as "price formation, price discovery, inventory, liquidity, transaction costs as well as information diffusion and dissemination in markets." (Econometrics of Financial High-Frequency Data, p.19)

The term was first used by Garman in his 1976 paper: "Market microstructure". Garman was interested in considering how spread prices would evolve given that supply and demand would arrive at different times.

We depart from the usual approaches of the theory of exchange by (1) making the assumption of asynchronous, temporally discrete market activities on the part of market agents and (2) adopting a viewpoint which treats the temporal microstructure, i.e., moment-to-moment aggregate exchange behavior, as an important descriptive aspect of such markets. (Garman 1976, p. 257, quoted in Hasbrouck Empirical Market Microstructure)

Market microstructure is one of the most interesting set of ideas in economics and finance, and of immense practical relevance to practitioners. It it tangentially related to important theories such as the Law of One Price, Rational Expectations, and the efficient markets hypothesis. Much of the underlying logic of standard microeconomics and finance is that market structure doesn't matter. Microstructure theory is explicitly about these frictions and costs, and how they lead to equilibrium.

Roadmap

I will be considering this field progressively. Starting with some basic considerations of trading mechanisms, rules, and important regulations. This forms a foundation for all subsequent work.

Following on Hasbrouck's Empirical Market Microstructure, I will start with a simple stochastic model -- the Roll Model -- introduced by Roll (1984). I will then move onto considering standard models microstructure models that consider market makers, or the sell side. There are currently two major types of models for explaining price formation: asymmetric information based models and inventory models. Inventory models were originally derived from Garman (1976). Asymmetric information models have received the most attention recently; there are two standard frameworks: the "sequential trade framework" by Glosten and Milgrom (1985) and the "strategic trade framework" developed by Kyle (1985).

I will then consider models that apply to how the buy side executes orders. This is slightly more disparate, but covers topics on transaction costs (especially market impact models), optimal trading models, and algorithmic trading. The optimal trading framework is based primarily on Bertsimas and Lo (1998) and Almgren and Chriss (2000).

Lastly, I will review some recent papers on high frequency trading, which covers a different paradigm from the original market maker model.

There are two useful survey papers on the subject:

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