Market microstructure is a specialized field in finance that studies how financial markets operate at the most detailed level. It examines the trading process, the mechanisms that bring buyers and sellers together, and how information flows through the market to determine prices.
Market microstructure examines five key components that work together to determine market outcomes. These include trading mechanisms which define how orders are matched, information flow that affects price movements, price discovery processes, market liquidity that determines ease of trading, and transaction costs that impact trading decisions.
Trading mechanisms are the systems that facilitate the matching of buy and sell orders. In order-driven markets, traders submit orders to an electronic order book where they are matched based on price and time priority. The order book displays the best bid and ask prices, with the difference between them called the bid-ask spread.
Price discovery is the fundamental process by which markets determine asset values. As new information enters the market from various sources like company earnings, economic data, or news events, traders quickly incorporate this information into their trading decisions, causing prices to adjust and reflect the new information.
Market liquidity and transaction costs are crucial factors in market microstructure. High liquidity markets have narrow bid-ask spreads, deep order books, and low transaction costs, making trading more efficient. In contrast, illiquid markets have wider spreads and higher costs, which can significantly impact trading strategies and market outcomes.