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Understanding Market Microstructure: Trading, Exchanges, and Market Performance

Explore the impact of market microstructure on trading, asset pricing, and market performance. Learn about trading industry, order properties, analytics, models, and more in this comprehensive study.

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Understanding Market Microstructure: Trading, Exchanges, and Market Performance

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  1. Trading, Exchanges, and Markets Kee H. Chung State University of New York at Buffalo

  2. What is market microstructure? • Traditional asset pricing aims to understand what should be the price of a security. • It does not, however, address how prices adjust to reflect news. • Nor does it explain how investors’ subjective assessment of a security “get into” the price.

  3. In practice, news and investors’ valuations are incorporated into security prices through trading. • This means that the specific trading rules, and the strategies traders develop in response to these rules, will affect how asset prices change over time in response to new information.

  4. “Market microstructure is the study of the process and outcomes of exchanging assets under explicit trading rules.”(Maureen O’Hara, a former president of the American Finance Association) • Market microstructure has a profound impact on the real world – on traders, broker/dealers, exchanges, regulators, and policy makers alike.

  5. Why do we care? • Data guided by theory, theory guided by data • Market design issues Agency auction market Dealer market Electronic limit order books

  6. Market performance issues • Transaction costs • Shock absorption/resiliency • Trading halts • Efficiency – welfare issues • Is insider trading bad?

  7. Topics to be covered Part 1: Foundation and Protocols • Trading industry • Orders and order properties • Market structure • Order-driven markets • Dealer markets • Why people trade

  8. Part 2: Analytics and Models • Bid-ask spreads • Insider trading • Measurement of trading (execution) cost • Adverse selection models • Spread component model • Performance measurement

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