 Market Microstructure: A Practitioner's GuideAnanth Madhavan Financial Analysts Journal, 2002, vol. 58, issue 5, 28-42 Abstract: Knowledge of market microstructure—how investors' latent or hidden demands are ultimately translated into prices and volumes—has grown explosively in recent years. This literature is of special interest to practitioners because of the rapid transformation of the market environment by technology, regulation, and globalization. Yet, for the most part, the major theoretical insights and empirical results from academic research have not been readily accessible to practitioners. I discuss the practical implications of the literature, with a focus on price formation, market structure, transparency, and applications to other areas of finance. Market microstructure concerns the process by which investors' latent or hidden demands are translated into executed trades. Interest in market microstructure is not new, but it has increased enormously in recent years because of the rapid structural, technological, and regulatory changes affecting the securities industry. Beyond these immediate concerns, however, the study of microstructure has broader practical value. A central concept in microstructure is that asset prices need not equal full-information expectations of value because of a variety of frictions. Thus, market microstructure is closely related to the study of the fundamental values of financial assets. Microstructure is also linked to traditional corporate finance because discrepancies between prices and value affect the level and choice of corporate financing.Knowledge of microstructure has grown explosively in recent years, but many important theoretical insights and empirical results from academic research are not readily accessible to practitioners. This article provides a practitioner-oriented review of the literature with an emphasis on the modern line of thought that focuses on information. The objective is to provide the reader with a valuable conceptual framework for attacking a variety of practical problems—current and future. The focus is on four broad topics within the field: first, price formation and price discovery—including both static issues, such as the determinants of trading costs, and dynamic issues, such as the process by which prices come to impound information over time. The goal is to look inside the “black box” by which latent demands are translated into realized prices and volumes;second, market structure and design issues, including the relationship between price formation and trading protocols. The focus is on how various rules affect the black box and, hence, liquidity and market quality;third, information, especially market transparency (i.e., the ability of market participants to observe information about the trading process). This topic deals with how revelation of the workings of the black box affects the behavior of traders and their strategies;fourth, the interface of market microstructure with corporate finance, asset pricing, and international finance. Models of the black box provide fresh perspectives on such topics as the underpricing of initial public offerings, portfolio risk, and foreign exchange movements. These categories roughly correspond to the historical development of research into the informational aspects of microstructure.Several conclusions from this survey of the literature are especially relevant for practitioners. First, markets are a great deal more complex than commonly believed. One of the major achievements of the microstructure literature is illumination of the black box by which prices and quantities are determined in financial markets. The recognition that order flows can have long-lasting effects on prices has many practical implications. For example, large price impacts may drive institutional traders to lower-cost venues, creating a potential for alternative trading systems. They can also explain the anomalous return behavior associated with periodic index reconstitution.Second, microstructure matters. Under certain protocols, markets may fail and large deviations between “fundamental value” and price may occur. These issues are especially relevant for exchange officials, operators of trading systems, regulators, and traders.Third, “one size fits all” approaches to regulation and policy making should be avoided. For example, greater transparency need not always enhance liquidity.Finally, the interface of microstructure with other areas of finance is an exciting new area. A more complete understanding of the time-varying nature of liquidity and its relationship to expected returns is needed; evidence is growing that liquidity is a “factor” in explaining stock returns. Differences in liquidity over time may explain variations in the risk premium and may, therefore, influence stock-price levels. Date: 2002 Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:taf:ufajxx:v:58:y:2002:i:5:p:28-42 Ordering information: This journal article can be ordered from Access Statistics for this article Financial Analysts Journal is currently edited by Maryann Dupes More articles in Financial Analysts Journal from Taylor & Francis Journals |
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