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Level 87

Market Microstructure


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Market Microstructure
Market Microstructure = Study of security trading and market making Subdiscipline of Finance
Primary Market
financial market where issues of a security are sold to initial buyers by the borrower
Secondary Market
Financial market where securities have been previously issued are resold
Participants
Informed Traders
Informed Traders
Informed Traders = Have private information about a security's true value vs. others don't have it = not public info
Active Liquidity Traders
Active Liquidity Traders = Must trade to meet their own needs (e.g., save for the future, etc.)
Passive Liquidity Traders
Passive Liquidity Traders = Try to make a profit by offering liquidity
Order types
Market Order
Market Order
an order to buy or sell at the best price available at the time the order reaches the exchange
Limit Order
an order to buy or sell at a designated price or at any better price
Order-driven = limit order market
Q: What order to you submit to "Hit the Bid"?
Hybrid market
Combination of order-driven and quote-driven (negotiation-based)
There is no dealer in an order-driven market
Q: What order do you submit to sell at the bid price?
Continuous
Trading Frequencies
Continuous with call
Continuous with call = continuous + opening call, closing call, & call after halt
Scheduled Call
Scheduled Call = orders accumulate; then at scheduled time match buys & sells
Request
Request = ask for quotes when you want to trade = search
CDA and Continuous CDA
CDA continuous Double Auction Simultaneous buy & sell Auctions
LP and CDA w/LP
LP liquidity Providers dealers
Firm quote
Firm quote = Dealer is committed to trade at bid and offer prices
Indicative quote
Indicative quote = Dealer is not committed = may update bid or offer price when you try to trade = used in fast changing market where old prices get stale fast
Trading Protocols
Order precedence
Order precedence
Order precedence = which order executes first
Primary priority
Primary priority = price
Secondary priority
Secondary priority = if tied on price, use another characteristic
Minimum trade quantity
Minimum trade quantity = smallest trade quantity
Minimum price increment
Minimum price increment = tick size = smallest price increment allowed
Three Modes of Price Discovery
Price Discovery = Process of learning what the updated price is
Bilateral Trading
Bilateral Trading = Dealer Market = One-on-one trading = each security trader trades with one dealer out of many dealers
Bilateral Trading and an Indicative quote
-Given indicative quotes, the security trader (client) can:
Continuous auction
Continuous auction = multilateral = many people trade with each other
Call Auction
Call Auction = Auction happens at fixed times (e.g., every hour)
Transaction Cost
Transaction Cost = Cost of trading
Measures: Market quality
Quoted Spread and calculation
Measures: Execution Cost
Effective Spread and calculation
Realized Spread
Measure: Trading intermediary profits
Other benchmarks to use, other than midpoint
In addition to the Midpoint, other benchmarks are used
Post-Trade
Post-Trade = benchmark is determined after trade
Intraday
Intraday = benchmark is determine contemporaneously
Pre-Trade
Pre-Trade = benchmark is determine before trade