Market Microstructure

What Is Market Microstructure?

Market Microstructure refers to studies initiated to understand how financial markets function and how trades are executed. Falling under the category of financial research, it comprises a detailed review of a financial market’s daily operations. The study aims to understand price movements, trader behavior, and trading processes.

Market Microstructure, a term related to financial research and intermediation, was coined in 1976 by Mark Garman. It analyzes stock market trades, quotes, prices, orders, and options. Stock market crashes may specifically prompt financial market microstructure studies as analysts frequently ponder the impact of such events.

• Market Microstructure is a detailed study of financial and security markets. It analyzes the operations of stock exchanges and evaluates the asset price determination process. Individuals can study each segment of the exchange.
• It was first propagated by Mark Garman in 1976. Later, others contributed to the theory. 
• The market microstructure theory received particular attention in the wake of stock market crashes.
• The basic elements analyzed in market microstructure studies include order book, asks and bids, order types, liquidity, HFT, dark pools, trader behavior, etc.

Market Microstructure Explained

Market Microstructure theory is a detailed overview of the financial markets comprising stocks, options, bonds, futures, currencies, and commodities. In simple words, it studies how exchanges work. Besides, it also considers the assets and instruments traded in financial markets. A definition by the National Bureau of Economic Research (NBER) states that these structures act as a platform for conducting theoretical, experimental, and empirical research to study the economies of the securities market.

As the number of financial markets has increased, more complex processes and technologies have been introduced. With several rapid changes occurring in financial markets around the world, investors and analysts feel the need to understand financial markets in their entirety. Market microstructure studies can help them identify and interpret the issues in these markets.

Market microstructure trading studies in different markets may include interpreting equity, foreign exchange, commodity, and bond markets. Price discovery, transaction costs, quotes, and spreads are some typical aspects observed during these studies. It also observes the trading preferences and behavior of intraday traders.

Components Of Market Microstructure

Due to the increase in the number of exchanges operating around the world, certain financial market microstructure components must be studied for better stock market evaluation. Some are listed below for reference:

#1 - Order Book

It refers to the buy and sell orders arranged by price. Order books contain information about the trade volume for various securities, assets, and financial instruments.

#2 - Market Liquidity

It refers to how swiftly an asset can be traded (bought or bold) without causing noticeable changes in its price.

#3 - Bids and Asks

In trading, a bid refers to the highest price a buyer offers to purchase an asset. In contrast, ask is the lowest selling price accepted by the seller.

#4 - Order Types

Various trading orders can be placed in the stock market while buying or selling an asset. This is a key point to be observed in the equity market microstructure study. Some order types are market orders, limit orders, stop-loss orders, fill or kill, immediate or cancel, etc.

#5 - High-Frequency Trading

High Frequency Trading refers to using advanced technology and algorithms to deal with trades in a matter of minutes. The high order volume can be swiftly processed using certain software applications.

#6 - Dark Pool

This is a private trading platform that operates with specific participants placing orders on financial instruments, including securities and derivatives. Transactions executed in dark pools are not public knowledge until they conclude.

#7 - Algorithmic Trading

In algorithm trading, advanced computer programs and machine learning algorithms make trading decisions, and orders are executed accordingly.

Examples

Let us consider the following examples of market microstructure trading to understand the concept.

Example #1

Suppose ABC Ltd is publicly listed on the New York Stock Exchange. To understand stock market dynamics, Sussane, a market microstructure analyst, studies the relevant market components. In one year, the stock saw frequent trades in the secondary market. Thus, for records, the stock exchange maintained an order book for ABC Ltd.

Conversely, several market participants tried to buy futures and stock options at different prices. If a trader wishes to buy 100 units, the exchange looks at the subsequent sell orders and places a trade. However, if the seller does not want to sell below $10,000, the buyer can put a limit order. The deal will be executed if it reaches the required price. However, if the trade is executed, it will influence the day’s candlestick.

This impact will cause the price to rise upward (candlesticks turning green). Witnessing this trend, other players may also initiate this process. They may use high-frequency and algorithmic trading to benefit from the price differences. As there are many buyers and sellers, the liquidity of ABC Ltd’s stocks will be high.

Sussane can note all these observations in her market microstructure theory study.

Example #2

According to an article dated June 2023, the S&P 500 reached a short-term high on June 16, 2023, due to projections of an impending recession. A market microstructure study states profit-taking began as the reversal (after a fairly long bear market rally) reached 4200.

Advantages And Disadvantages

Let us study the advantages and disadvantages of market microstructure theory.

Advantages	Disadvantages
Market microstructure understands asset price deviation that occurs despite long bear or bull runs/rallies. It gives a detailed view of the components of financial markets.	Market microstructures differ from one market to another. Therefore, common studies may not give the right results.
Market microstructure facilitates price determination studies under various market conditions.	Operations costs like order, transaction, and processing costs affect investment returns. They must be considered to derive reliable inferences.
It acknowledges transaction costs. How market participants and traders influence prices becomes clear.	As algorithmic trading and HFT have gained considerable popularity, concerns of potential market abuse have increased. Hence, observations may be lopsided at times.

Frequently Asked Questions (FAQs)

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