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Security Market Microstructure: The Analysis of a Non-Frictionless Market

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Handbook of Quantitative Finance and Risk Management

Abstract

The Capital Asset Pricing Model describes a frictionless world characterized by infinite liquidity. In contrast, trading in an actual marketplace is replete with costs, blockages, and other impediments. Equity market microstructure focuses on how orders are handled and turned into trades in the non-frictionless environment. For over three decades, the literature has grown while, concurrently, trading systems around the world have been reengineered. After depicting the frictionless CAPM, we consider the development of microstructure analysis, concentrating on issues germane to market architecture. We then consider the design of one facility, Deutsche Börse’s electronic platform, Xetra. Important insights were gained from the microstructure literature during Xetra’s planning period (1994–1997), and Xetra’s implementation marked a huge step forward for Germany’s equity markets. Nevertheless, academic research and the design of a real world marketplace remain works in progress.

This chapter includes material from Francioni et al. (2008) and from Schwartz (1988), which was reprinted in Schwartz and Francioni (2004).

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Notes

  1. 1.

    For a recent discussion, see Davis et al. (2007).

  2. 2.

    For a discussion of the Taylor procedure see, for example, R. G. D. Allen, Mathematical Analysis of Economists, London, England: Macmillan, 1960.

  3. 3.

    Two further assumptions are required to obtain Equation (21.3): (1) the third derivative of utility with respect to wealth is small enough to ignore; and (21.2) the squared deviation of the expected rate of return on the risky asset from the risk-free rate is small enough to ignore.

  4. 4.

    Another major issue addressed by the microstructure literature at that time was the impact of information on trading volume and price (Copeland 1976; Beja and Hakansson 1977; Beja and Goldman 1980).

  5. 5.

    For further discussion, see Cohen et al. (1979).

  6. 6.

    A market supported by informational trading only can indeed function if agents trade with each other because their expectations are divergent. When the information that triggers trading is common knowledge, the condition may be thought of as one where agents are agreeing to disagree.

  7. 7.

    Cohen et al. (1981) describe the tradeoff between execution probability and price improvement in the optimal choice between limit and market orders.

  8. 8.

    See Bach and Baruch (2007) for a recent discussion and further references.

  9. 9.

    See Economides and Schwartz (1995) for a description of alternative call market structures.

  10. 10.

    Trading systems differ in their degree of transparency. Pagano and Röell (1996) investigate whether greater transparency enhances market liquidity by reducing the opportunities for taking advantage of uninformed participants.

  11. 11.

    Also see Hasbrouck (1995), Harvey and Huang (1991) and Jones et al. (1994). Further references are provided by Menkveld et al. (2007).

  12. 12.

    Also see Bessler (2006) for discussion and further references.

  13. 13.

    For further discussion and references regarding liquidity see Amihud and Mendelson (1986), Chordia et al. (2000, 2008), Hasbrouck and Seppi (2001), Amihud (2002) and Pastor and Stambaugh (2003).

  14. 14.

    Adaptive valuation behavior refers to individual agents becoming more bullish (bearish) when learning of the relatively bullish (bearish) attitudes of others.

  15. 15.

    Further discussion of market structure development is provided by Harris (2003).

  16. 16.

    FWB also owned the futures and options exchange Deutsche Termine Börse. After the 1997 merger with SOFFEX, DTB became Eurex.

  17. 17.

    For further discussion and descriptions, see Francioni et al. (2008).

  18. 18.

    Appendix B provides details of Xetra’s design.

  19. 19.

    Interestingly, the microstructure literature on call auctions was relatively sparse at that time. For an early discussion, see Handa and Schwartz (1996b).

  20. 20.

    For further discussion, see J. Pratt, “Risk Aversion in the Small and the Large,” Econometrica, January 1964.

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Authors and Affiliations

  1. Zicklin School of Business, Baruch College, CUNY, New York, NY, USA

    Sonali Hazarika & Robert A. Schwartz

  2. Deutsche Börse, Frankfurt, Germany

    Reto Francioni & Martin Reck

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  1. Reto Francioni
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  2. Sonali Hazarika
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  3. Martin Reck
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  4. Robert A. Schwartz
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Editors and Affiliations

  1. Department of Finance and Economics, Rutgers University, 94 Rockafeller Road, Janice H. Levin Bldg., New Brunswick, NJ, 08854-8054, USA

    Cheng-Few Lee

  2. State Street Corp., Boston, MA, 94132, USA

    Alice C. Lee

  3. Center for PBBEF Research, North Brunswick, NJ, USA

    John Lee

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Francioni, R., Hazarika, S., Reck, M., Schwartz, R.A. (2010). Security Market Microstructure: The Analysis of a Non-Frictionless Market. In: Lee, CF., Lee, A.C., Lee, J. (eds) Handbook of Quantitative Finance and Risk Management. Springer, Boston, MA. https://doi.org/10.1007/978-0-387-77117-5_21

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