Chapter 9. Market Microstructure

Market microstructure deals with the purest form of financial intermediation – the trading of a financial asset, such as a stock or a bond. In a trading market, assets are not transformed but are simply transferred from one investor to another. The field of market microstructure studies the cost of trading securities and the impact of trading costs on the short-run behavior of securities prices. Costs are reflected in the bid-ask spread (and related measures) and in commissions. The focus of this chapter is on the determinants of the spread rather than on commissions. After an introduction to markets, traders and the trading process, I review the theory of the bid–ask spread in Section 3 and examine the implications of the spread for the short-run behavior of prices in Section 4. In Section 5, the empirical evidence on the magnitude and nature of trading costs is summarized, and inferences are drawn about the importance of various sources of the spread. Price impacts of trading from block trades, from herding or from other sources, are considered in Section 6. Issues in the design of a trading market, such as the functioning of call versus continuous markets and of dealer versus auction markets, are examined in Section 7. Even casual observers of markets have undoubtedly noted the surprising pace at which new trading markets are being established even as others merge. Section 8 briefly surveys recent developments in securities markets in the USA and considers the forces leading to centralization of trading in a single market versus the forces leading to multiple markets. Most of this chapter deals with the microstructure of equities markets. In Section 9, the microstructure of other markets is considered. Section 10 provides a brief discussion of the implications of microstructure for asset pricing. Section 11 concludes.