Market Microstructure

MARKET MICROSTRUCTURE

Objective of mkt microstructure: look at the trading process and how info are incorporated into

prices.

In trading there’s a problem of find a counterparty (search problem): buyers need to find sellers and

vice versa→ every trader wants to trade at a good price: sellers seek buyer willing to pay high prices

and buyer seek seller willing to sell at a lower price.

Liquidity providers, such as mkt makers or dealers, that are financial institutions ready to sell/buy

when the counterparty is ready.

KPI of trading desk: key performance indicator Trading is not investing

1. Speed of execution • Trading is all about converting an investment

2. Costs of execution decision (either yours or your portfolio

manager’s) into a desired portfolio position

MKT microstructures is a combination of 3 areas: – You will want to do this at the least possible

cost and in the most timely fashion

→

1. Institutional aspects regulation and trading rules

→

2. Empirical analysis statistical and econometric tools

→

3. Theoretical foundations microeconomic concepts, demand-supply dynamics.

Perfect capital markets characteristics:

1. All potential buyers and sellers are present on the mkt and are price takers

→

2. All trade at a single mkt-clearing price there’s just 1 price instead of the bid-ask price that

can be observed in the order book.

3. This price reflects everyone’s consensus view→ for the perfect price only fundamentals

matter→ no room for overreaction to news and inefficiencies. In reality fundamentals are

important, but we know that the mkt is often inefficient bc people overreact to news.

4. No frictions: brokerage commissions, transaction taxes, bid-ask spread, cost of acquiring info

(in reality they are present)

5. Order flow has no effect on prices

Real world characteristics:

1. Not everyone participates all the time: in each moment, the prices are determined by few

participants who absorb the orders (mkt makers)→ exchanges have closing days.

2. Frictions are present

3. Order flow affects transaction prices

4. Prices may deviate from the consensus price

Two pillars of the course

- MKT LIQUIDITY

- PRICE EFFICIENCY (speed of price discovery) 1

→

ILLIQUIDITY Degree to which transaction prices (Pt) deviate from the consensus value

(Wt) of the security.

Transaction price (Pt): price that we can observe for ex. on Bloomberg.

Consensus value (Wt): true value of the asset.

→ Perfect markets: Pt = Wt.

→ →

Real markets: Pt ≠ Wt transaction costs arise

Our views of liquidity:

1. Mkt liquidity = ability to trade a security quickly and at its consensus (fundamental value)

2. Funding liquidity = ability to obtain credit at acceptance terms, or to have sufficient cash to

→

meet obligations without incurring large losses. When a mkt is illiquid request for

→

withdrawals from bank deposits is not possible liquidity spiral that reflects the connection

between bank liquidity and mkt liquidity.

→

3. Monetary liquidity money supply by the CB.

4. Liquidity also affects cost of capital for firms: if I need my money back, it is easier if the

company’s stocks are more liquid, but a liquid company can charge higher prices reflecting a

lower cost of capital, because they can enjoy the fact that their stock will be more liquid in

the future. Low liquidity stocks provide higher returns to convince investors to buy them, this

discount means larger cost of capital for the firm, because if I need to raise the same amount

off equity, I need to issue more shares, but also reflects in higher returns for the investor.

Una società con azioni più liquide può permettersi di chiedere prezzi più alti per le sue azioni quando

emette nuovo capitale, il che si traduce in un costo del capitale inferiore. Questo perché gli investitori

sono disposti a pagare di più per le azioni liquide, sapendo che sarà facile venderle in futuro senza

difficoltà.

D'altro canto, le azioni con bassa liquidità devono offrire rendimenti più alti per attrarre investitori.

Questo è necessario perché gli investitori sono meno disposti ad acquistare azioni difficili da

rivendere; quindi, devono essere compensati con un maggiore ritorno potenziale. Questo maggiore

rendimento per gli investitori rappresenta un costo del capitale più elevato per l'azienda. Se l’azienda

vuole raccogliere lo stesso ammontare di capitale, dovrà emettere un numero maggiore di azioni (a

un prezzo inferiore), aumentando il costo complessivo.

In sintesi: una maggiore liquidità riduce il costo del capitale per l'azienda e offre rendimenti inferiori

agli investitori, mentre una minore liquidità richiede rendimenti più elevati per gli investitori,

aumentando il costo del capitale per l'azienda.

→

PRICE DISCOVERY speed and accuracy with which transaction prices incorporates

available info. →

Security mkt can be very good in incorporate pieces of info and using them to price assets

important for investors bc minimizing execution costs = maximizing investors’ return. Bonuses for

the trading desk should only be related to the execution performance, in order to have more efficient

orders. 2

• Market microstructure (MM) affects investors welfare

– Transaction costs shrink investor net return

– Different trading strategies satisfy different trading needs (trade-off between speed of execution and costs)

• MM affects firms cost of capital

– Low liquidity stocks are required to compensate investors with greater returns

• MM studies affect securities regulation

– US financial regulation: Christie e Schultz (JF 1994) Harris on

decimalization (2000-2001)

– EU financial regulation: the Lamfalussy process and the consultations running on a systematic basis

INTRODUCTION TO MARKET MICROSTRUCTURE: SECURITIES TRADING AND

TRADING MECHANISMS

MKT TYPES: 2 types →

1. Auction markets (mercati d’asta): centralized, direct trading stock exchanges: NYSE,

LSE, Borsa Italiana.

2. Dealer markets: not centralized, intermediated trading→ ex. OTC derivative mkt

In mkts transparency and rules are fundamental, and rules can be public and private, and they can be

applied both, they are set by:

- Regulation and self-regulation→ ex. self – regulation is used in crypto mkts (white papers)

- Role of governance of exchanges

- Role of competition between exchanges

- Role of technological innovation

TRDING VENUES →

1. Regulated exchanges rules approved by NCA (= national competent authority)

2. Alternative trading system: ECN (electronic communication networks), crossing networks

(where rules are not approved)

3. OTC: operated by dealers, less regulated, ex. Nasdaq

4. Internalization: In this case, the financial institution (like a bank) acts as the broker-dealer,

directly matching or filling client orders from its own account. Instead of sending the order to

a stock exchange, the process stops at the bank, which serves as the dealer, especially if the

customer wants to buy the bank's own shares.

PLAYERS:

Buyside = traders who buy trading services

• Individuals (retail)

• institutions (wholesale): mutual funds, pension funds, firms, government

Sell side = traders who sell trading services:

• dealers: trade on own account

• brokers: trade on behalf of clients

• broker-dealers (dual traders): do both Central Counterparty

LIFE CYCLE OF AN ORDER: TRADING AND POST-TRADING

1. transmission of the order to the trading venue by a broker

2. order executions (how to make the trade done)

3. clearing with a CCP (optional for OTC and for internalization): CCP establishes obligations of

buyer and seller, validate trade, prepares it for netting

4. settlement (not always required for internalization) = securities are transferred from seller to buyer

and funds from buyer to seller. 3

BASIC TRADING MECHANISMS

La differenza principale tra auction (order dirven) e dealership (quote driven) riguarda il modo in

cui avviene la formazione del prezzo e la gestione delle transazioni.

L'auction market (order-driven) è un

sistema centralizzato in cui i prezzi degli

asset sono determinati dagli ordini di

acquisto e vendita inseriti dagli investitori.

Customers send orders to an “auctioneer”

(device that balance demand and supply,

now automated). demand and supply are

consolidated in 1 trading platform→ Gli

ordini si incrociano automaticamente

quando c'è corrispondenza tra prezzo di

domanda (acquisto) e prezzo di offerta

(vendita). Un esempio è la borsa valori, ex.

NYSE.

Il dealership market (quote-driven) invece è un sistema decentralizzato in cui i dealer/mkt makers

(intermediari) offrono continuamente prezzi di acquisto e vendita per gli asset. Gli investitori

comprano o vendono direttamente dai dealer al prezzo quotato, come avviene nel mercato valutario

(Forex).

→In sintesi: il sistema ad asta è basato sugli ordini dei partecipanti, mentre il sistema a negoziazione

è basato sui prezzi forniti dai dealer.

TYPES OF ORDERS:

→ →

MARKET ORDERS buy or sell at the best LIMIT ORDERS set the quote (number of

available price: shares) at a limited maximum price (buy) or

minimum price (sell):

no price indication: “instruction to trade a Price indication: instruction to trade at the best

quantity at the best price currently available in price available if it is not worse than specific

the limit price

-

market”→ buy/sell a given quantity at the best Pro: may get good price for trade

-

current possible price. Con: may not execute (execution risk)→ risk

- Pro: quick (demands immediacy, consumes that the order is not executed

liquidity)

- Con: may get worse price (pay for

immediacy and liquidity)

“Market orders pay the bid-ask spread.

Market Order: è un ordine di comprare o vendere un'azione o un altro strumento finanziario al

miglior prezzo disponibile al momento dell'esecuzione. 4

- Vantaggi: L'ordine viene eseguito quasi immediatamente, purché ci sia sufficiente liquidità nel

mercato.

- Svantaggi: Non si ha controllo sul prezzo finale dell'esecuzione. Il prezzo potrebbe essere

leggermente diverso da quello visualizzato, soprattutto in mercati volatili. Mkt orders pay the bid-

ask spread.

Esempio: Se vuoi comprare 100 azioni di una società e inserisci un market order, l'ordine sarà eseguito

al prezzo di mercato più basso disponibile in quel momento. Non hai garanzie sul prezzo preciso che

otterrai.

Limit order: permette di specificare un prezzo massimo (per un acquisto) o minimo (per una vendita)

al quale sei disposto a fare l'operazione.

- Vantaggi: L'ordine viene eseguito solo al prezzo specificato o migliore. Hai più controllo sul

prezzo.

- Svantaggi: L'ordine potrebbe non essere eseguito affatto se il mercato non raggiunge il prezzo

limite specificato.

Esempio: Se vuoi comprare 100 azioni di una società, puoi inserire un limit order a 50€. L'ordine

verrà eseguito solo se il prezzo scende a 50€ o meno.

Differenze Chiave:

Market Order: Priorità sulla velocità di esecuzione rispetto al prezzo.

Limit Order: Priorità sul controllo del prezzo, ma l'esecuzione potrebbe non avvenire se il prezzo

desiderato non viene raggiunto.

La scelta tra i due tipi di ordine dipende dalle tue priorità: rapidità o controllo del prezzo.

In financial markets, there are two main types of orders: market orders and limit orders. When an

order enters the market, it essentially becomes a "limit order market" because only limit orders remain

active.

Difference Between Market Order and Limit Order:

1. Market Order: This type of order is executed immediately at the best available price. When

you submit a market order, you want it completed right away, regardless of the price. It

consumes liquidity because it "takes" from the order book the quantities already offered→

they demand liquidity bc they consume liquidity offered by limit orders; they clear out limit

orders. This reduces the available quantity in the bid/ask spread.

2. Limit Order: With this order, you decide the price at which you want to buy or sell. For

example, if you're buying and set a lower limit price than the current price, the order will

remain pending until a seller is found willing to meet your price. These orders provide

liquidity to the market because they remain in the order book (LOB - Limit Order Book) until

executed→ they provide liquidity bc they give other traders the opportunity to trade.

In the past, fees were the same for both market and limit orders. However, stock exchanges (which

make money through trading fees) introduced more advanced pricing strategies. Today:

Limit Orders: Pay lower fees because they increase market liquidity. Limit orders are

• considered beneficial to the market as they create more trading opportunities.

Market Orders: Pay higher fees because they consume liquidity, reducing available

• quantities and accelerating the closure of already pending limit orders. 5

LOB: The limit order book contains all limit orders that are waiting to be executed. These orders wait

until a market order meets their conditions (price and quantity). If a trader wants their order to be

executed faster, they might decide to offer a higher price (for a buy order) or accept a lower price (for

a sell order) to meet the counterparty in the market more easily.

Ex. If there are already limit orders waiting in the LOB and you want to buy shares quickly, you can

do two things:

1. Use a Market Order: The order will be executed immediately at the best available price, but

you might pay more and consume liquidity.

2. Use a Limit Order with a Higher Price: If you want to increase the chances of your order

being executed, you can set a higher limit price than those already in the LOB. This way, your

order will be more competitive and will have a higher probability of being executed.

→ Stock exchanges favor the use of limit orders by offering lower fees because they help maintain

market liquidity. On the other hand, market orders are charged more because they take liquidity away,

reducing the quantities available in the bid/ask spread.

There are other less common types of orders, but the most frequent ones are limit orders and market

orders:

- Stop orders: a strategy where once the stock price reaches a specified level the position must be

liquidated. If I’m long and I buy a stock at 10 and then I set the maximum loss at 20%, once the

price reaches 8 then at that point in time, I will liquidate my position. The pro of this type of order

is to limit the losses when the trader is not present on the trading desk, but also a way to mitigate

the losses so it can work as a risk management tool; once risk that we have to take into account is

that when we take a decision the stock price can always go in the opposite way with respect to

the expected one, so using this type or order is useful technique even if we thought that our

decision was good. The con is that it demands liquidity when least available, so for example if

everyone is selling, we must sell as well getting an even worse price.

- Hidden (iceberg) order: Limit order only part of which is visible, the rest “emerging” as the

visible part executes against incoming orders. This type of orders is helpful because disclosing

the traders’ intentions is something that can go against them, because if it is known that they want

to buy, sellers will raise prices, so maintaining part of their trading intentions private can be very

good. In practice this means that the order will not be displayed entirely immediately because

trading intentions are sensitive to information. È un ordine parzialmente nascosto

che serve a ridurre l’impatto sul

mercato e proteggere informazioni

AUCTION MARKETS: CALL VS CONTINUOUS sensibili sulle proprie strategie di

trading.

We can distinguish auction mkts in two types:

1. Call auction markets: they are also called batch (= a lotto) because they are consolidated in one

point in time; usually they have a call at the beginning of the trading day and at the end of it. In

this market all traders enter the orders to buy to construct the demand function (decreasing price)

and the order to sell to construct the supply function (increasing price). The price is set such that

supply=demand and all orders are executed at the same price, called call price, opening price

or closing price. In this type of markets, we do not pay the bid-ask spread because there is no

difference between bid and asks since the price is just one. 6

Gli ordini che non possono essere eseguiti subito (non-marketable orders), ad esempio quelli rimasti inevasi dopo

l’asta di apertura, vengono inseriti nel limit order book (LOB), cioè un registro che raccoglie tutti gli ordini in attesa,

ordinati per prezzo e tempo di inserimento. Quando arriva un market order (un ordine da eseguire subito), questo

viene abbinato agli ordini nel LOB seguendo la priorità di prezzo — prima quelli con prezzo più vantaggioso — e, a

parità di prezzo, la priorità temporale.

2. Continuous auction markets: “non-marketable” orders (e.x. those not executed in the initial

call) are placed in a limit order book (LOB); Incoming market orders are executed against the

LOB according to price and time priority rules.

→In sintesi, i nuovi ordini di mercato vengono eseguiti abbinandoli agli ordini nel LOB in base al

prezzo più vantaggioso e, a parità di prezzo, in base all’ordine di arrivo.

Why Traders Avoid Market Orders:

If you can’t see the LOB, you don’t know what the best price someone is willing to pay is. This

uncertainty is why professional traders prefer to use limit orders. For example, if you want to buy at

a maximum of 73.60, and the current best-selling price is 73.45, your limit order will execute at 73.45.

However, if prices change quickly, you might still pay up to 73.60.

In securities markets, the demand curve is not linear; it has the shape of a descending staircase.

Each limit order represents a step on this curve, showing that as prices decrease, the quantity that

people want to buy increases.

In an auction mkt, before the opening hour, traders enter their orders in the trading system and then

at the opening time the book will be constructed to define the call price.

→ each limit order has its own price, while mkt orders are placed at the highest point bc they will be

executed at whatever ask price.

Sell side curve is constructed in the same way but in the opposite direction.

Once all traders submit their

orders the opening price is set,

and no trader will be punished

for overbidding (=offering a

higher price than the one that has

been set as equilibrium price).

So, there’s an incentive in

overbidding. Since overbidding

can be an incentive to get the

trading done, regulation can

prohibit to submit market orders

in some specific periods, such as

the days after the IPO.

If we place a market order, we're

"free riding" because we don't

really know the asset's value, and we're not helping to determine the price. In contrast, with limit

orders, we consider the asset's potential value, which helps with price discovery.

In this graph, the order is only partially filled because the demand (green line) is lower than the

supply (red line). This means only part of my order will be executed at my desired price.

l’ultimo acquirente al prezzo di equilibrio riesce a comprare solo in parte (non tutto ciò che

aveva richiesto), perché l’offerta si esaurisce a quel punto.

When an investor submits a market order, they agree to trade at the market price without contributing to its

formation. This behavior is described as “free riding”, since the trader benefits from the price discovery process

carried out by others who place limit orders — these orders reflect informed expectations about the asset’s true

value.

In a call auction, no trader is punished for overbidding, meaning that offering a higher price than the equilibrium

one has no negative consequence, since all trades are executed at the same final price. This creates an

incentive to overbid to ensure execution. However, to prevent distortions, especially right after an IPO,

regulations may restrict the submission of market orders during certain periods. 7

In summary, limit orders play a key role in determining the market price and enhancing transparency, while

market orders allow for immediate execution but do not contribute to price formation.

All the other orders are called non-

marketable order bc they are not

executed in the call auction, so they are

used to form the limit order book. The

orders on the right side of the crossing

point between demand and supply are

the unfiled one, so they can be seen as a

representation of the LOB.

Il bid-ask spread aumenta con la

dimensione ed è dato dalla differenza tra

il prezzo di acquisto (bid) e il prezzo di

vendita (ask). Se la quantità che

vogliamo acquistare è superiore alla

quantità offerta al miglior prezzo di vendita, “cammineremo” lungo il libro ordini, il che significa

che eseguiremo il nostro ordine a prezzi diversi, che saranno più alti (sulla funzione dell'offerta).

Example

Time is a relevant variable bc if I’m faster than other traders, I’ll be able to get my order executed at

better conditions. In this LOB we can see the priority in

terms of time on the ask side since two

orders are at 74.38 but there’s a priority

for the first one that submitted the order 5

milliseconds before.

In the past, with physical exchanges the

geographic position was relevant, while

when electronic exchanges were

introduced, traders could enter all at the

same time meaning that location was not

important. Now with the concept of time

the location is relevant again because

traders closest to the exchange will be

faster in submitting the order, so they will

enjoy the priority of execution.

Exchanges can offer rents of space in their servers for those who want to be very close to the

exchange. 8

DEALER MARKET To act like a dealer, you need to

have a warehouse of securities

(=inventory position, leading to

an inter-dealing market).

At some point in time dealers

may ran out of securities, so they

can ask to different d