Markets microstructure deals with issues of market structure and design, price formation and price discovery, transaction and timing cost, information and disclosure, and market maker and investor behavior. National Bureau of Economic Research (NBER) defines market microstructure as a field of study that is devoted to theoretical, empirical, and experimental research on the economics of security markets. It includes the role of information in the price discovery process, the definition, measurement and control of liquidity, and transaction costs and their implication for efficiency, welfare, and regulation of alternate trading mechanisms and market structures.
Contrary to Efficient Market Hypothesis, the basis of Market Microstructure is that asset prices need not reflect full information. Frictions such as competition for order flow, rules and trading protocols and information asymmetry cause friction.
For a stock market to function properly, a structure is needed to facilitate the placing of orders, provide equal information for all investors and speed the execution of the trades ordered. A question that begs the answer is “Why do we need market microstructure?” A simple answer would be it tries to answer how prices are formed in the economy. Let us explore the types of markets.
Types of Markets
Order-driven market: These markets use trading rules to arrange their trades. All traders essentially participate equally, placing orders on an order book that are matched following a consistent set of rules. Priority is one of the important rules. Price is given the first priority and time is given the second priority in the order book.
Quote-driven market: Transaction takes place between traders and dealers or market makers. They will buy and sell a given quantity for the quoted prices. The prices the market markers quote are firm since they play a role in providing liquidity.
Hybrid market: While allowing direct negotiation between counterparties with the huge trading volumes, this market is in principle an order-driven market.
The generic classification is as follows:
Brokers: Transmit order for clients, act as conduits for the clients’ orders.
Dealers: Trade for their own account and/or also facilitate client orders (broker/dealer).
Market makers: Quote price to buy or sell. Take position in the security.
Market microstructure is mainly about the different order types. Trader gives an order to the broker who acting as the trader’s agent directs the order to a market where the trade may be arranged. The trader must specify the exact number of shares to be traded. In addition, the trader should instruct the price at which the trade is to be made. Based on trader’s price specification, orders might be classified into market orders or limit orders. Let us have a peek into the different order types.
Market orders: A buy or sell order to be executed at the best price established on the market. For a market order seller (buyer), the best price is the highest(lowest) bid(ask) posted by the potential buyer(seller).
Limit orders: A limit buy (sell) order specifies the maximum (minimum) price at which the trader will buy (sell). Price limits for buyers (sellers) are normally placed at prices below (above) the current price at which shares can be bought (sold). Limit orders that do not execute when they are placed remain active on the book until they execute, are withdrawn, or expire.
GTC orders: A Good Till Cancelled order is a buy or sell a stock at a set price that is active until the investor decides to cancel it or the trade is executed. If an order does not have a good-’til-canceled instruction then the order will expire at the end of the trading day the order was placed.
Market orders are uncertain in terms of price but certain in terms of execution whereas limit orders are uncertain in terms of execution but certain in terms of price. There are some priority rules based on which orders are executed. These trading priority rules can be classified as follows:
Trading Priority Rules
Price priority rule: Buyers posting higher bids have priority over buyers posting lower bids. Similarly sellers posting lower asks have priority over sellers posting higher asks.
Time priority rule: Order that is placed first is executed first.
Size priority rule: Order with the largest size is executed first.
Pro rata rule: Orders that are tied to the same price are executed.
Market microstructure aims at providing better liquidity in the markets and reducing volatility. Indian stock exchanges NSE and BSE introduced pre-open call auction session to achieve these objectives. The pre-open session lasts for 15 minutes from 9 AM to 9:15 AM and is divided into three parts.
- From 9 AM to 9:08 AM, the orders are placed. They can also be canceled or modified during this time period.
- From 9:08 AM to 9:12 AM, price discovery will be done and the orders will be executed.
- From 9:12 AM to 9:15 AM, facilitating the transition from pre-open to regular session is done.