Market Microstructure and Design


Market microstructure implies the details of the many ways in which exchange occurs in markets. For example the prices of different types of goods can either be negotiated, are fixed price or bid for in an auction. The type of the product conventionally determines the method of price fixing. For instance, art and antiques are bid for at an auction, while items of every day use such as vegetables and pulses are sold in the retail market at a fixed price. The price of housing, on the other hand, is negotiated with the help of a broker.

Market microstructure includes both the exchange of real and financial assets. However, more evidence is available on the microstructure of financial markets because of the easy availability of transactions data from such markets. Market microstructure research examines the ways in which the working process of a market affects trading costs, prices, volume, and trading behaviour.

Market microstructure studies the process and outcomes of exchanging assets under a specific set of rules. For example the stock market has its own specific trading process. Shares of specific companies are offered by brokers at specific prices ranges or at one fixed cost. The buyers too bid for shares through brokers at fixed prices. If there is a match, the transaction goes through and the shares change hands. Here both the buyer and the seller factor in the cost of brokerage as well as any transaction tax applicable when deciding on the price of a particular share.

The microstructure of the securities market (as that of other markets) is impacted by the information available during the price discovery process, that is information such as how keen the seller and buyer are to dispose of or possess the share, repectively, the market sentiment (is it going through a bull or bear phase) as well as the liquidity (how keen are other market players to acquire the share) and transactions costs. The higher the transaction cost, the lower is the liquidty of a particular share. Typically, high volumes do not occur when the transaction costs are high. One example would be the real estate market which becomes sluggish if the local registration taxes are high.

Besides these, the price of the share is determined by information about the company as well as the sector in which the company operates.

Market structure and design:

The relationship between price determination and trading rules affect market structure and design. In some markets, for example, assets are traded through dealers that keep an inventory of new products (such as soaps and detergents), while in other markets brokers act as intermediaries (such as in the used car market). Microstructure research studies the way in which market structure affects trading costs and tries to determine if one market structure is more efficient than the other.

Price formation and discovery:

Price formation and discovery are affected by the methods used to fix prices. For example, in some markets prices are determined through auction (such as in the art market at Christies), in other markets prices are negotiated (such as housing) or simply posted (such as in grocery stores) and buyers can decide whether to buy or not.

Transaction cost and timing cost:

Transaction and timing costs too need to be factored in and the impact of the transaction cost on investment returns and execution methods too determine the price of a share or any other product.

Information and disclosure:

Market information and transparency also impact the price of shares. For instance, if a particular share is known to be purchased by a big investor or the management of the company buys back some of its shares or big mutual funds disclose that they have a heavy exposure in one share, then individual market participants too try to acquire shares in that company. Some owners of the shares might decide to sell their stock at a higher price to take advantage of the demand.