Market Microstructure

Martin Sewell
Department of Computer Science
University College London

2007

Market microstructure is a branch of economics and finance concerned with

the details of how exchange occurs in markets, most commonly financial mar-
kets. Market microstructure research typically examines the ways in which the
working process of a market affects trading costs, prices, volume and trading
behaviour.

• Garman (1976) used a collection of market agents to model both ‘dealer-

ship’ and ‘auction’ markets.
• Morse and Ushman (1983) examined the effect of information announce-
ments on the bid/ask spreads. They found no significant changes in
bid/ask spreads surrounding quarterly earnings announcements, but sig-
nificant increases in the size of bid/ask spreads are found on the day of
large price changes.
• Amihud, Mendelson and Murgia (1990) studied the impact of the stock
market microstructure on return volatility and on the value discovery pro-
cess in the Milan Stock Exchange; the primary trading mechanism em-
ployed by this exchange is a call market, which is usually preceded and
followed by trading in a continuous market. They found that the opening
transaction in the continuous market had the highest volatility, and that
opening the market with the call transaction seemed to produce relatively
lower volatility.
• Reinganum (1990) investigated the influence of market microstructure on
liquidity premiums. Premiums of a competitive, multiple-dealership mar-
ket (NASDAQ) were contrasted with those of a monopolistic, specialist
system (NYSE). The NASDAQ appeared to have a liquidity advantage
over the NYSE for small firms but not for large companies.

• In Bossaerts and Hillion (1991), four continental European currencies with

respect to the French franc were examined, and the bid–ask spread in the
spot and forward foreign exchange markets when some traders have supe-
rior information about government intervention was investigated. Larger

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 bid-ask spreads on Fridays were documented. Reliable evidence of asym-
metric bid-ask spreads for all days of the week, albeit more pronounced
on Fridays, were presented.
• Lease, Masulis and Page (1991) investigated the importance of bid-ask
spread-induced biases on event date returns as exemplified by seasoned
equity offerings by NYSE listed firms. They document significant nega-
tive return biases on the offering day. Buy-sell order flow imbalance was
prominent around the offering and induces a relatively large spread bias.
• Allen and Gorton (1992) explain that buyers wish to avoid trading with
informed investors, will usually be able to choose the time at which they
trade, and so will tend to cluster. So when liquidity buyers are not clus-
tering, purchases are more likely to be by an informed trader than sales
so the price movement resulting from a purchase is larger than for a sale.
As a result, profitable manipulation by uninformed investors may occur;
and the authors present a model where the specialist takes account of the
possibility of manipulation in equilibrium.
• Dubofsky (1992) proposed a market microstructure explanation of the
positive abnormal returns found on ex-stock distribution days. The ab-
normal returns are argued to be the result of NYSE Rule 118 and AMEX
Rule 132, which dictate how open limit orders to buy and sell stock are
handled on ex-days.
• Loughran (1993) demonstrated that the relatively poor performance of
small NASDAQ securities relative to the performance of similarly-sized
NYSE securities during the 1973–1988 period was largely due to initial
public offerings (IPOs), rather than market microstructure differences (on
average, IPOs underperform during the six calendar years after going pub-
lic).
• Huang and Stoll (1994) developed a two-equation econometric model of
quote revisions and transaction returns and used it to identify the relative
importance of different microstructure theories and to make predictions.
Microstructure variables and lagged stock index futures returns had in-
sample and out-of-sample predictive power based on data observed at
five-minute intervals. The most striking microstructure implication of the
model, confirmed by the empirical results, specified that the expected
quote return is positively related to the deviation between the transaction
price and the quote midpoint while the expected transaction return is
negatively related to the same variable.
• Wang, et al. (1995) examined the Real Estate Investment Trust (REIT)
market microstructure and its relationship to stock returns. When com-
pared with the general stock market, REIT stocks tend to have a lower
level of institutional investor participation and are followed by fewer secu-
rity analysts. Also, REIT stocks that have a higher percentage of institu-

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 tional investors or are followed by more security analysts tend to perform
better than other REIT stocks.
• Park (1995) examined the impact of bid-ask bounce on variations in stock
returns following large price changes. By using the average of the bid-
ask prices in the sample selection process, the previously reported price
reversal on the day following the events (day +1) disappears. However,
for a short-run period after day +1, systematic abnormal return patterns
are still observed (but the profits from a contrarian investment strategy
designed to exploit the patterns would not cover transaction costs).
• Maureen O’Hara wrote Market Microstructure Theory (O’Hara 1995),
which provides a comprehensive guide to the theoretical work.
• Brennan and Subrahmanyam (1996) investigated the empirical relation
between monthly stock returns and measures of illiquity obtained from
intraday data. They found a significant return premium associated with
both the fixed and variable elements of the cost of transacting. The re-
lation between the premium and the variable cost was concave, which is
consistent with clientele effects caused by small traders concentrating in
the less liquid stocks. However, the relation between the premium and the
estimated fixed cost component was convex.
• Campbell, Lo and Mackinlay (1996) contains a chapter on market mi-
crostructure which covers nonsynchronous trading, the bid-ask spread and
modelling transactions data.
• Hasbrouck (1996) provided an overview of the various approaches to mod-
elling microstructure time series.
• Spulber (1996) considers market microstructure and intermediation.
• Amihud, Mendelson and Lauterbach (1997) showed that improvements in
market microstructure are valuable. Specifically, they found that stocks
that were transferred to a more efficient trading method in the Tel Aviv
Stock Exchange enjoyed significant and permanent price increases.

• Spulber (1999) wrote Market Microstructure: Intermediaries and the The-

ory of the Firm, which presents a theory of the firm based on its economic
role as an intermediary between customers and suppliers. He applies the
term ‘market microstructure’ generically to refer to the operation of mar-
kets for all types of goods and services.

• MacKinnon and Nemiroff (1999) examined the effect of the move to dec-
imalization by the Toronto Stock Exchange and found an unambiguous
gain to investors. Effective spreads decreased significantly, yet price im-
pact was unaffected, thus reducing transaction costs, and there was an
increase in trading activity.

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• Madhavan (2000) reviewed the theoretical, empirical and experimental
literature on market microstructure relating to (1) price formation, (2)
market structure and design, (3) transparency and (4) applications to
other areas of finance.
• Kauffman and Wang (2001) studied the dynamics of an instance of dy-
namic pricing—group-buying discounts—used by MobShop.com, whose
products’ selling prices drop as more buyers place their orders. They
found a positive participation externality effect, a price drop effect and a
significant ending effect.
• Muscarella and Piwowar (2001) studied a sample of Paris Bourse stocks
that were transferred between call trading and continuous trading. They
found that frequently-traded stocks that are transferred from call trad-
ing to continuous trading experience, on average, liquidity improvements
that are positively associated with price appreciation; and infrequently-
traded stocks that are transferred from continuous trading to call trading
experience price and liquidity declines.
• Cheung and Chinn (2001) reported findings from a survey of United
States foreign exchange traders. They found that (i) in recent years
electronically-brokered transactions have risen substantially, mostly at the
expense of traditional brokers; (ii) the market norm is an important de-
terminant of interbank bid-ask spread and the most widely-cited reason
for deviating from the conventional bid–ask spread is a thin/hectic mar-
ket; (iii) half or more of market respondents believe that large players
dominate in the dollar–pound and dollar–Swiss franc markets; and (iv)
exchange rate predictability is viewed as fairly low (surprisingly, there is
little variation in the proportion of traders who hold this view over the
various horizons—from intraday to over six months).
• Hasbrouck (2002) provided an overview of econometric approaches to char-
acterizing the random-walk component in single- and multiple-price set-
tings.
• Larry Harris published Trading and Exchanges: Market Microstructure for
Practitioners (Harris 2002), an excellent book about trading, the people
who trade securities and contracts, the marketplaces where they trade and
the rules that govern it.
• Dominguez (2003) explored whether aspects of market microstructure in-
fluence the effectiveness of central bank intervention. Her results indicated
that some traders typically know that the Fed is intervening at least 1 hour
prior to the Reuters’ report that a central bank is intervening, and the
effects of interventions generally persist, at least to the end of the day.
There was evidence of mean reversion in returns subsequent to Fed in-
terventions particularly in the USD–DEM market, suggesting some initial
over-reaction by the market. Also, the evidence suggested that the timing

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 of intervention operations matters—interventions that occur during heavy
trading volume, that are closely timed to scheduled macro announcements,
and that are coordinated with another central bank are the most likely to
have large effects.
• In an excellent review paper, Biais, Glosten and Spatt (2005) surveyed
the literature analyzing the price formation and trading process, and the
consequences of market organization for price discovery and welfare.
• Aı̈t-Sahalia, Mykland and Zhang (2005) consider the question of how often
to sample a continuous-time process in the presence of market microstruc-
ture noise, and their answer is: model the noise and sample as often as
possible.
• Hansen and Lunde (2006) analyzed the properties of market microstruc-
ture noise and its influence on empirical measures of volatility, and ex-
amined a simple bias correction of the realized variance. An empirical
analysis of the 30 stocks that comprise the Dow Jones Industrial Average
revealed that market microstructure noise is (1) time-dependent and (2)
correlated with increments in the efficient price. The results were estab-
lished for both transaction data and quotation data and were found to
hold for intraday returns that are based on both calendar-time sampling
and tick-time sampling.
• Hasbrouck (2006) published Empirical Market Microstructure: The In-
stitutions, Economics, and Econometrics of Securities Trading, the first
integrated introduction to the most important models of empirical market
microstructure.

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