Market Microstructure

• What's to be covered:
– Basic trading concepts

– Types of markets

– Traders

– Trading process

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 Introduction
• Market Microstructure is a branch of economics
concerned with the functional set-up of a market.
•
• Market microstructure deals with the trading of financial
assets, such as a stock or a bond.

• It deals with the manner in which securities are traded and

how that process affects prices of assets traded, volumes
traded and the behaviour of traders.

• It also takes into account efficiency and liquidity of the

market.

• We will look at the trading environment as well as the

agents involved; types of traders, markets, and the
outcome of the trading process.
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Examples of typical microstructure questions:
• Does the trading mechanism of an exchange
affect the speed with which information is
incorporated into price?

• How do trading arrangements affect the optimal

trading strategies of institutional and retail
investors respectively?

• If traders have the option of operating in more

than one trading venue which venue will they
choose and why?
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 Basic concepts
• Bid price- The bid price is that price at which a dealer is
willing to purchase a security. This is the price that one
would receive for an immediate sale of a unit of stock.

• Ask price or offer – An ask price is that price at which

the dealer will sell a security. This is the price charged
for immediate purchase of stock.

• Bid-ask spread - this is the difference between the ask

price and the bid price.

• The ask price should exceed the bid price. Otherwise

one could buy a unit of stock (paying the ask) and
immediately resell the unit of stock (at the bid) to make a
profit.

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 Market efficiency and market liquidity
• Markets efficiency – a market is said to be efficient with
respect to a given information set if no agent can make
economic profit by trading on such information.

• Three forms of pricing efficiency:

• Weak form efficiency – means that the price of the
security reflects the past price and trading history of the
security.

• The idea of weak-form efficiency led to the formulation of

the random work model of stock prices; which states that
prices follows a random walk.

• What this implies is that the difference between

successive prices cannot be forecasted.

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• Semi-strong efficiency – means that the
price of the security fully reflects all
available public information.

• Strong form efficiency – means that the

price of a security reflects all information,
whether it is publicly available or known
only to insiders of the firms.

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 Market Liquidity
• Markets are said to be liquid if trading costs are low and
volumes traded are high. This implies that an economic
agent can cheaply alter the composition of his/her
portfolio in very liquid market than in a less liquid market.

• A liquid market is one which is:

• Tight – which means that cost of trading small amounts
are themselves small (i.e. bid-ask spreads are small).

• Deep – cost of trading large amounts are small - that is

big trades do not cause price movements.

• Resilient - discrepancies between prices and true values

for the asset in question are small and corrected quickly.

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 Why is a liquid market desirable?
• A highly liquid market is a desirable trading venue, as
trading costs are low.

• This leads to increased numbers of trades being

executed on the market

• This in turn increases liquidity. (i.e. liquidity leads to

liquidity)

• Overall, as Ross Levine (a World Bank Economist)

would say, “investors come if they can leave”.

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 Types of markets
• Auction market-A pure auction market is one in which
investors (usually represented by a broker) trade directly
with each other without the intervention of dealers.
• Call auction market-A call auction market takes place
at specific times when the security is called for trading. In
a call auction, investors place orders – prices and
quantities – which are traded at a specific time according
to specific rules, usually at a single market clearing price.
• Continuous auction market-In a continuous auction
market, investors trade against resting orders placed
earlier by other investors and against the “crowd” of floor
brokers.
• Continuous auction markets have two-sides: Investors,
who wish to sell, trade at the bid price established by
resting buy orders or at prices in the “crowd,” and
investors, who wish to buy, trade at the asking price
established by resting sell orders or at prices in the
“crowd.”
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 Pure Dealer Market
• A pure dealer market is one in which dealers post bids
and offers at which public investors can trade.

• The investor cannot trade directly with another investor

but must buy at the dealers ask and sell at the dealers bid.
Bond markets and currency markets are dealer markets.

• Dealer markets are physically dispersed and trading is

conducted by telephone and computer.

• By contrast, auction markets have typically convened at a

particular location such as the floor of an exchange.

• With improvements in communications technology, the

distinction between auction and dealer markets has
lessened.
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 Types of orders
• The two principal types of orders are a market order and
a limit order.

• Market order - A market order directs the broker to trade

immediately at the best price available. Essentially, a
market order is a straight-forward request to buy/sell
immediately. They do not specify a price at which to sell
or buy a security.

• A market order implies price uncertainty since the agent

giving the order to buy or sell does not know the price to
be charged.

• It however implies execution certainty. For example a

market order to buy 100 IBM shares would execute with
certainty at the best price available.
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• Limit order - A limit order to buy sets a maximum price
that will be paid, and a limit order to sell sets a minimum
price that will be accepted.

• Limit orders are therefore price contingent. If one submits

a limit order to buy 100 ABSA shares at R60 per share
then the order will only be executed if a seller who is
willing to sell such shares at R60 or less is available.
Such a seller may not be present implying that the order
may not be executed.

• A limit order is characterized by execution uncertainty

and price certainty.

• Traders who are more patient tend to choose limit orders.

Less impatient traders are more likely to use market
orders, and thus pay a premium for instant execution.
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 Types of traders
• Traders in markets may be classified in a variety of
ways:
– Active versus passive
– Liquidity versus informed
– Individual versus institutional
– Public versus professional

• Active versus passive

• Some traders are active (and normally employ market
orders), while others are passive (and normally employ
limit orders).

• Active traders demand immediacy and push prices in the

direction of their trading, whereas passive traders supply
immediacy and stabilize prices. Passive traders tend to
earn profits from active traders. 13
 Liquidity versus informed
• Liquidity traders trade to smooth consumption or to adjust
the risk-return profiles of their portfolios.

• They buy stocks if they have excess cash or have become

more risk tolerant, and they sell stocks if they need cash or
have become less risk tolerant.

• Informed traders trade on private information about an

asset’s value. Liquidity traders tend to trade portfolios,
whereas informed traders tend to trade the specific asset
in which they have private information.

• Liquidity traders lose if they trade with informed traders.

Consequently they seek to identify the counterparty.
Informed traders, on the other hand, seek to hide their
identity.
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 Individual versus institutional
• Institutional investors – pension funds, mutual funds, etc.
They are the dominant actors in stock and bond markets.

• They hold and manage the majority of assets and

account for the bulk of share volume. They tend to trade
in larger quantities.

• Individual investors trade in smaller amounts and account

for the bulk of trades. The structure of markets must
accommodate these very different players.

• Institutions may wish to cross a block of 100,000 shares

into a market where the typical trade is for 3,000 shares.
Markets must develop efficient ways to handle the large
flow of relatively small orders while at the same time
accommodating the needs of large investors to negotiate
large transactions. 15
 Public versus Professional
• Public traders trade by placing an order with a broker.

• Professional traders trade for their own accounts as

market makers or floor traders and in that process
provide liquidity.

• Computers and high speed communications technology

have changed the relative position of public and
professional traders.

• Public traders can often trade as quickly from upstairs

terminals (supplied to them by brokers) as professional
traders can trade from their terminals located in offices
or on an exchange floor.
• Regulators have drawn a distinction between
professional and public traders and have imposed
obligations on professional traders.
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 The trading process
• The elements of the trading process may
be divided into four components:

• Information

• Order routing

• Execution

• Clearing
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• First, a market provides information about past prices
and current quotes. Transaction prices and quotes are
disseminated. The dissemination of these prices makes
all markets more transparent and allows investors to
determine which markets have the best prices, thereby
enhancing competition.

• Second, a mechanism for routing orders is required.

Today brokers take orders and route them to an
exchange or other market center. Retail brokers
establish procedures for routing orders and may route
orders in return for payments.

• The third phase of the trading process is execution. In

today’s automated world this seems a simple matter of
matching an incoming market order with a resting quote.
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• However this step is surprisingly complex and
contentious. Dealers are reluctant to execute orders
automatically because they fear being “picked off” by
speedy and informed traders, who have better
information.

• Instead, they prefer to delay execution, if even for only

15 seconds, to determine if any information or additional
trades arrive.

• Automated execution systems have been exploited by

speedy customers to the disadvantage of dealers.
Indeed, as trading becomes automated the distinction
between dealers and customers decreases because
customers can get nearly as close to “the action” as
dealers.

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• Clearing
• A less controversial but no less important phase
of the trading process is clearing and settlement.

• Clearing involves the comparison of transactions

between buying and selling brokers.

• These comparisons are made daily. Settlement

in U.S. equities markets takes place on day t+3,
and is done electronically by book entry transfer
of ownership of securities and cash payment of
net amounts to the clearing entity.

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