Market Microstructure

Liquidity

Why should we care for illiquid markets?

Asset managers and ordinary investors care about liquidity insofar as it affects the return on

their investments, simply because illiquid securities cost more to buy, and sell for less.

Therefore, illiquidity eats into the return.

Illiquidity affects equilibrium prices, which must discount not only risky future cash >lows

generated by the asset, but also the future trading costs that its holders may incur and the

associated risks.

The need to compensate investors for illiquidity creates a link between the >ield of market

microstructure and that of asset pricing.

The tree dimensions of liquidity

a) market liquidity. Ability to trade a security quickly at a price close to its consensus value

(used for this course).

b) funding liquidity. Having suf>icient cash or the ability to obtain credit at acceptable terms,

to meet obligations without incurring large losses.

Funding liquidity is related to market liquidity in several ways. Investors value market

liquidity, that is, they prefer assets that can be sold quickly in case of need at prices not far

from their fundamental value.

Second, funding liquidity is itself a prerequisite for market liquidity. For instance, market

makers often need access to credit to maintain a large enough inventory of the securities in

which they are dealing, because they do not have enough equity. Hence, the more abundant

and cheaper is the market makers’ funding liquidity, the greater is the liquidity of security

markets.

This reciprocal feedback between market and funding liquidity becomes particularly

important in times of crisis, when it can lead to liquidity spirals, with market liquidity

suddenly drying up for many securities at once.

c) monetary liquidity. In practice liquidity is often identi>ied with money itself, whether

de>ined as the cash held by households and >irms and bank reserves (“monetary base”), or as

broader monetary aggregates that also include bank deposits of various types (M1, M2, or

M3).

This notion of liquidity also bears some relationship to the previous two: expansion of the

money supply by the central bank (say, via open market purchases of bonds or “quantitative

easing”) increases the supply of funds to banks and thus tends to increase funding liquidity,

and with it market liquidity, as we have seen. By the same token, a monetary contraction can

be expected to reduce both funding and market liquidity.

Liquidity varies across securities: larger, more widely-held securities generally enjoy better

liquidity than smaller issues.

Liquidity is sometimes characterized as a network effect or network externality. Just as one

person’s bene>it from a telephone depends on how many other people can be reached over the

telephone system, liquidity depends on how many other people hold and (by implication)

trade the security. If many people are active in a market, it is easier to >ind a counterparty.

Market Structure

Trading may be prompted by various factors: the need to mitigate risks (hedging), the desire

to exploit superior information (speculation), or the urge to rebalance one’s portfolio

(liquidity shocks).

All trading mechanisms can be viewed as variations of two basic structures: limit order

market and dealer market.

In limit order markets (auction markets) the >inal investors interact directly; their bids and

offers are consolidated in a limit order book (LOB) according to price priority, so that higher

bids and cheaper offers are more likely to be executed. By contrast, in dealer markets >inal

investors can only trade at the bid and ask quotes posted by specialized intermediaries, called

“dealers” or “market makers,” and these quotes are not consolidated to enforce price priority.

Limit Order Markets and Dealer Markets

Centralized trading mechanisms in which potential participants can show their interest in

trading by submitting orders, which then are matched directly by trading platforms. Typical

examples are such electronic trading platforms for equities as BATS in the United States or

Chi-X in Europe. At the opposite extreme, all trades in dealer markets are intermediated by

professional intermediaries that quote ask prices, at which the public can buy securities from

them, and bid prices, at which the public can sell to them. That is, buyers and sellers do not

trade directly with each other. A good example is the corporate bond market in the United

States and in Europe. These are typically over-the-counter (OTC) markets, where brokers

must shop around dealers to get the best prices and dealers have no obligation to post

continuous two-way quotes.

Limit Order Markets

Orders go into an LOB, which determines the priority with which they will be matched with

offsetting orders. In call (or batch) markets, incoming orders are stored in the LOB and then

matched at discrete intervals, such as once per day. In continuous markets, they are matched

immediately with orders already present on the LOB, if possible; otherwise they are stored in

the LOB to await future execution.

1) Continuous Limit Order Markets. When submitting orders to a continuous limit order

market, investors can design them differently depending on their trading needs. The most

basic choice, which determines both speed and price of execution, is between limit and

market orders.

An order with a price limit is called a limit order. An example is an order to “buy 100 shares,

limit 102”. If the market ask price is 101 when the buy order arrives, the buy order is

considered marketable. There is an immediate execution, at 101.

A market order is communicated without a price limit. “I will pay the market offer, however

high that offer might be”. If it is 101, it will be bought at 101, if 110, then 110,… and so on.

A buy limit order speci>ies the maximum price at which the trader is prepared to buy a stated

amount of the security; similarly, a sell limit order speci>ies the minimum price the seller will

accept for a given amount. A market order only speci>ies an amount to buy or sell, not the

price: it will therefore be executed at whatever price it can fetch on the market.

Limit orders may not >ind a counterpart with which they can be matched at the speci>ied price.

Market orders, by contrast, are >illed immediately if there is any outstanding limit order on the

other side of the market. Thus, one difference between limit and market orders is that limit

orders do not guarantee immediate execution—indeed, they may never be executed at all—

whereas market orders are executed immediately upon submission.

In the LOB, we see the limit orders on the bid and ask sides: buy limit orders (bids) are

arranged in decreasing order of price, sell limit orders (asks) in increasing order.

Consider an investor who wants to buy nine hundred shares. He has two options. One is to

place a buy market order for this amount. In this case, the order is executed immediately

against the best limit orders to sell (on the ask side): >irst it will >ill the >irst limit order of 800

for 74.48, then the second for 100 at 75.74, so that its average execution price is 74.62.

Trading Mechanics and Market Structure

The second option is to place a buy limit order for 900 shares. If he speci>ies a limit price

lower than 74.48, the order is entered in the LOB on the bid side and stored for future

execution. If he enters a limit price equal or higher to 74.48 (the best price on the ask side of

(bids) are arranged in decreasing order of price, sell limit orders (asks) in increasing

the limit book) then the order is marketable: it can be executed at once, at least partially,

order. The LOB also shows size and time, that is, the number of shares specified and the

against stored sell limit orders, in this example those at 74.48. If the order speci>ies a limit

price of 74.50, the remaining 100 shares will appear on the bid side of the LOB as a buy limit

(p.19)

time the order was

order at 74.50. Figure 1.2. Example of limit order book (LOB)

Hence, the choice between a market and a limit order involves a trade-off between immediate

execution at current market prices and a more favorable transaction price at the cost of

entered in the book. Depending on the market’s trading rules, only a subset of the

delayed and uncertain execution.

orders present in the LOB may be visible to market participants. As we shall see later,

this is one dimension of market transparency.

The LOB >igure can also be used to illustrate the notion of illiquidity. If the market were

perfectly liquid, we wouldn’t have bid-ask spread; in reality we have a spread of

Consider an investor who wants to buy nine hundred shares. He has two options. One is

74.48-74.42=0.06; it is a measure of illiquidity.

to place a buy market order for this amount. In this case, the order is executed

For larger orders, there is the need to compute the weighted average bid-ask spread. The

immediately against the best limit orders to sell (on the ask side): it will first fill the two

buy price rises with order size (the buyer has to walk up the schedule of sell limit orders to >ill

limit orders placed at the offer price of $74.48 for eight hundred shares, and then be

his own buy order); the sell price is decreasing with the size of the order, as the seller has to

executed for the remaining hunded shares against the limit order at $75.74, so that its

walk down the schedule of buy limit orders. Thus larger orders are associated with a greater

difference between the average execution price for buy and sell market orders. A market in

average execution price is $74.62. Note that the order of priority in which limit orders on

which investors can trade large quantities without substantially moving the price (where the

the book are executed depends on their price: aggressively priced orders are filled

weighted b-a spread does not increase much with trade size) is said to be deep.

before less competitive ones. In other words, execution obeys a price priority rule. If

two limit orders have the same price, they are filled according to secondary priority rules

The LOB evolves in real time as market and limit orders are submitted. In our example, the

such as time of submission or pro-rata allocation (fractional execution proportional to limit

submission of the buy market order for 900 shares depleted the LOB on the ask side and so

order size).

widens the b-a spread from 0.06 to 1.58. By contrast, if the buyer summits a limit order at

74.45, the b-a spread narrows to 0.03. Since market orders widen the spread, traders

The second option for the investor is to place a buy limit order for nine hundred shares.

submitting there orders are called liquidity demanders (takers). In contrast, those

If he specifies a limit price lower than $74.48, the order is entered in the LOB on the bid

submitting limit order are called liquidity suppliers (makers).

side and stored for future execution. The level of the chosen bid price determines the

likelihood and speed of execution, as more aggressively priced buy orders are executed

Hidden orders are limit orders that are stored in the LOB but not displayed to market

first according to price priority.

participants. These orders will be executed in the same way as regular limit orders, but they

usually lose time priority against limit orders that are displayed at the same price. A variant of

If the investor instead specifies a limit price equal to or higher than $74.48—that is, if he

the hidden limit order is the so-called iceberg order, for which a fraction of the actual size is

matches or crosses the best price on the ask side of the limit book—then the order is

shown to other market participants along with the price. As the order is executed, the hidden

(p.20)

marketable: it can be executed at once, at least partially, against stored sell limit

size becomes gradually evident to market participants.

orders, in this example those at $74.48. If the order specifies a limit price of $74.50, the

remaining hundred shares will appear on the bid side of the LOB as a buy limit order at

$74.50. Significantly, the transaction price ($74.48) is determined by existing prices on the

LOB, not by the price of the incoming marketable limit order.

2) Call limit orders

The limit order markets is known as a call auction. Before the call auction is held, market and

limit orders gradually accumulate in the LOB unless cancelled.

Trading Mechanics and Market Structure

In the call auction, differently from the continuous limit order market, all executable orders

are cleared at the same price. For this reason, the call auction is sometimes called a single or

uniform price auction.

partial execution. Buy limit orders below the clearing price or sell orders above it are not

More precisely, at the time of the call auction, all the buy orders in hand are sorted in

filled. It is easy to see that the clearing price maximizes the (voluntary) trading volume, as

decreasing order of limit price, with buy market orders treated as at the highest possible

it leaves no trading opportunity unexploited.

price. This determines the cumulative quantity that traders are prepared to buy at each

possible price. Symmetrically, the sell orders are sorted by increasing limit price, with sell

In the past, many exchanges in continental Europe were essentially call markets. Walras

market orders treated as at the lowest possible price. This determines the cumulative quantity

(1874) was inspired by the mechanism of the Paris Bourse

that would be sold at each possible price.

Trading Mechanics and Market Structure

partial execution. Buy limit orders below the clearing price or sell orde

filled. It is easy to see that the clearing price maximizes the (voluntary

it leaves no trading opportunity unexploited.

In the past, many exchanges in continental Europe were essentially ca

(1874) was inspired by the mechanism of the Paris Bourse

Figure 1.3. Call auction

The price set in the auction (the market-clearing o equilibrium price) is determined by the

(p.23)

point where demand and supply interact. At this price, orders from all buyers with a bid

higher than the clearing price and all sellers with a price below that clearing price are fully

executed. Limit orders with a price just equal to the clearing price (the marginal traders) may

be partially executed. For instance, in >igure 1.3, the total demand at the clearing price exceeds

the total supply, so the marginal buyer will get only partial execution. Buy limit orders below

the clearing price or sell orders above it are not >illed. It is easy to see that the clearing price

maximizes the (voluntary) trading volume, as it leaves no trading opportunity unexploited.

Figure 1.3. Call auction

In the past, many exchanges in continental

(p.23)

Europe were essentially call markets.

Today, with the advent of computerized trading,

Figure 1.4. Forming the initial limit order book of the trading day

the call mechanism serves mainly to determine

the opening price before the start of continuous

call auction when he formalized the process by which supply and demand are balanced in

limit order trading on trading platforms such as

competitive markets. Today, with the advent of computerized trading, the call mechanism

the LSE, Italian Stock Exchange, Madrid… In this

serves mainly to determine the opening price before the start of continuous limit order

case, the limit orders un>illed at the opening call

auction form the initial LOB for the continuous

trading on trading platforms such as the NYSE-Euronext, LSE, Italian Stock Exchange,

session. Figure 1.4 shows this initial LOB in the

and Madrid Stock Exchange. In this case, the limit orders unfilled at the opening call

case of the call auction displayed in >igure 1.3

auction form the initial LOB for the continuous session. Figure 1.4 shows this initial LOB in

Figure 1.4. Forming the initial limit order book of the trad

and illustrates that the bid-ask spread on the LOB

the case of the call auction displayed in figure 1.3 and illustrates that the bid-ask spread

increases with trade size, as noted. Some markets also use the call auction to set the closing

on the LOB increases with trade size, as noted. Some markets also use the call auction to

call auction when he formalized the process by which supply and dem

price at the end of the trading day.

set the closing price at the end of the trading day.

competitive markets. Today, with the advent of computerized trading,

Call auctions are used as the only trading mechanism for stocks that are traded infrequently. In

serves mainly to determine the opening price before the start of conti

this way, market organizers make sure that there is suf>icient interest on both sides of the

Call auctions are used as the only trading mechanism for stocks that are traded

trading on trading platforms such as the NYSE-Euronext, LSE, Italian

market. They increase the likelihood of >inding a counterpart for each side while reducing the

infrequently. In this way, market organizers make sure that there is sufficient interest on

and Madrid Stock Exchange. In this case, the limit orders unfilled at th

both sides of the market. They increase the likelihood of finding a counterpart for each

auction form the initial LOB for the continuous session. Figure 1.4 sho

side while reducing the risk that the clearing price will be distorted by a temporary

the case of the call auction displayed in figure 1.3 and illustrates that th

on the LOB increases with trade size, as noted. Some markets also us

contact a dealer, find out his price, and trade at this price, or else try ano

in a dealer market there is a sharp distinction between liquidity suppliers

and liquidity demanders (final investors), whereas in a limit order market

(p.24)

chooses whether to provide or to demand liquidity.

risk that the clearing price will be distorted by a temporary imbalance between supply and

demand. For instance, on the LSE, SETSqx is a trading platform that runs four electronic

auctions a day (alongside a dealer market) for securities that are less liquid than those traded

Trading Mechanics and Market Structure

on SETS.

Dealer Markets

imbalance between supply and demand. For instance, on the LSE, SETSqx is a trading

platform that runs four electronic auctions a day (alongside