Market microstructure is a branch of finance that deals with the details or explanations of how exchanges happen in the markets. Although the concept of the market microstructure can be used in the exchange of actual or financial assets, there is a fascinating indication on the microstructure of financial markets due to the accessibility of data from transactions from the financial markets.
The research of market microstructure deals with how the working processes impact factors which determine the trading behavior, transaction quotes, and costs, volumes, and prices. Recent studies have allowed people to dig deeper into how market abuse affects market microstructure. This includes broker-client conflict, market manipulation, and insider trading.
Market microstructure deals with the following issues or factors:
- Market structure and design. This mostly focuses on the connection between trading rules and price determination. In some markets, for example, goods are sold through traders who keep an inventory, like new cars and machinery, while other markets are controlled by brokers/agents who act as intermediaries between the buyer and the seller, for example, real estate. One of the key question in market microstructure research is how trading costs are affected by the market structure, and whether one market structure is more efficient compared to others. Market microstructure explains the performance of the market participants, and whether dealers, investors, and investor admins comply with the authorities. Therefore, the market microstructure is an essential factor that impacts investment decisions and also investment exit.
- Price information and discovery. This factor concentrates on the ways in which the price of a commodity is determined. For instance, in some market settings, the prices of the products are determined through an auction process, in other markets, prices are arrived at through negotiations or by the seller, while in others, the buyer can opt to buy or not.
- Transaction cost and timing cost. This focuses on both transaction and timing costs, and how transaction cost impacts ROI and execution methods. Examples of transaction costs include monopoly power, processing costs, inventory holding costs and adverse selection costs.
- Information and disclosure. This factor concentrates on the market information and transparency, and how the marker information affects how the market participants behave.