Market Microstructure
Market Microstructure is the branch of finance that studies the details of how exchange occurs in markets. While Asset Pricing asks "What is the fair value of Apple?", Microstructure asks "How exactly do we buy Apple shares?"
Market Structures
1. Quote-Driven Markets (Dealer Markets)
- Mechanism: Dealers (Market Makers) quote Buy and Sell prices. You trade against the dealer.
- Example: Forex, Bonds, OTC Derivatives.
- Key: You don't see other traders, you only see the Dealer.
2. Order-Driven Markets (Auction Markets)
- Mechanism: All Buy and Sell orders are displayed in a central Limit Order Book. A matching engine pairs them up.
- Example: Stock Exchanges (NSE, BSE, NYSE, Nasdaq).
- Key: Traders trade with other traders.
The Participants
- Informed Traders: Have private information (or better analysis). They buy because they know price will go up.
- Uninformed (Noise) Traders: Trade for liquidity needs (e.g., need cash) or gambling.
- Market Makers (Liquidity Providers): Provide buy/sell quotes to earn the spread. They don't care about direction; they just want volume.
Note
Adverse Selection: Market Makers hate Informed Traders. If an Informed Trader buys from a MM, the MM sold too low and will likely lose money when the price rises. This risk forces MMs to widen the spread.
Price Discovery
Microstructure explains how latent demand/supply translates into a visible price.
- Auctions: Opening/Closing bells often use a "Call Auction" to find an equilibrium price.
- Continuous Trading: During the day, price is discovered continuously as orders hit the book.
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