Market Microstructure, Trading Mechanisms and Exchanges

  • Luc Bauwens
  • Pierre Giot
Part of the Advanced Studies in Theoretical and Applied Econometrics book series (ASTA, volume 38)


In this first chapter, our goal is twofold. First, we present the most important types of market mechanisms that are used to trade shares in key financial exchanges such as the NYSE, the NASDAQ, the Paris Bourse and the FOREX (currency trading). While the list of well-known and important financial exchanges is certainly not limited to these four places, these four markets provide a comprehensive collection of trading mechanisms, most of which are used in other financial centers as well.


Limit Order Market Maker Order Book Tick Size Market Microstructure 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.


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  1. 1.
    Limit buy and sell orders and the computerized trading system at the Paris Bourse and NYSE are detailed later in this chapter.Google Scholar
  2. 2.
    In the pure Walrasian auction, supply is equal to demand at the market clearing price. In most practical applications of this scheme, and because traders submit mostly limit orders, it would be impossible to ensure that all buy orders are matched with all sell orders. That’s the reason why the price is usually determined such that the traded volume is maximized.Google Scholar
  3. 3.
    Domowitz (1993) introduces a taxonomy of automated trade execution systems, which allows an easy classification of the existing automatic trading systems.Google Scholar
  4. 4.
    The definition of the technical terms are given in the glossary at the end of this chapter. These terms are set in bold characters the first time they are used.Google Scholar
  5. 5.
    In a market maker system, the buy and sell can take place at different times. For example, the first trader can sell the asset to the market maker at 10 am, and the market maker could sell the asset to the second trader at 11 am.Google Scholar
  6. 6.
    The tick size depends on the stock and is set by rules defined by the exchange where the stock is traded. For example, the tick size of most stocks traded on the NYSE is equal to. For stocks of which share prices are close to $1 or $2, the tick size can be as low as. Since January 29th, 2001, this rule has been changed as the NYSE now quotes all its stocks in decimal form, with the tick size being equal to 1 cent.Google Scholar
  7. 7.
    Trading mechanisms at the London Stock Exchange have usually been of the price driven types; today, due to increasing competition from the other European Exchanges, the trading system is evolving towards a hybrid system, i.e. a market maker system in combination with an electronic order book.Google Scholar
  8. 8.
    Other rules are possible. For example, at the NYSE, orders entered by traders have time priority over orders entered by specialists in the order book.Google Scholar
  9. 9.
    See for example Pagano (1998) for a survey of European equity markets.Google Scholar
  10. 10.
    Liquidity is ari important topic in market microstructure. See for example Pagano (1998), O’Hara (1995) or Biais, Foucault and Hillion (1997) for additional discussion on this topic. Pascual, Escribano and Tapia (1999, 2000) present a recent application to NYSE data and provide numerous references to this subject.Google Scholar
  11. 11.
    Indeed, the viability of a pure order book trading system is not obvious by itself. See Handa, Schwartz and Tiwari (1997) for a discussion regarding the interaction between market orders and limit orders entered in the order book.Google Scholar
  12. 12.
    SEAQ stands for Stock Exchange Automated Quotations and is a computer-based quotation system for the London Stock Exchange where market makers can enter their bid-ask quotes.Google Scholar
  13. 13.
    Lee (1998) provides a general discussion of the role played by exchanges.Google Scholar
  14. 14.
    Gordon (1999) provides a colourful, easy to read, narrative of the emergence of Wall Street.Google Scholar
  15. 15.
    For a complete description of the trading procedures at the NYSE, see Hasbrouck, Sofianos and Sosebee (1993).Google Scholar
  16. 16.
    Super-DOT (Super Designated Order Turnaround) is an electronic trading system meant for small orders. With this system, the brokerage firms can send their customer’s orders directly to the trading post of the specialist. Next to Super-DOT, there is also ITS (Intermarket Trading System) which is a telecommunication network binding the NYSE, the NASDAQ and the regional exchanges.Google Scholar
  17. 17.
    For a comprehensive description of orders, see Sharpe, Alexander and Bailey (1999).Google Scholar
  18. 18.
    Market-on-open orders are market orders that are to be executed right at the open of the trading session.Google Scholar
  19. 19.
    For largely traded stocks like Microsoft, Cisco Systems or Dell, this number can easily be over 50!Google Scholar
  20. Level 2 screens display continuously the bid-ask quotes of all market makers, while Level 3 screens add the possibility of entering quotes and limit orders in the system.Google Scholar
  21. 21.
    This is called Level 1. The difference between the best bid-ask prices is called the inside spread.Google Scholar
  22. 22.
    See Chung and Van Ness (2001).Google Scholar
  23. 23.
    A locked quote is a quote where the bid price is higher than the ask price.Google Scholar
  24. 24.
    The London Exchange created the SEAQ international quote-driven trading system in 1986 to attract trading volume from continental exchanges, as it allows the trading of non-UK shares listed in Paris, Brussels, Madrid,…Google Scholar
  25. 25.
    While the acronym CAC is most often used, the trading system was updated in 1996 and is now formally called NSC (Nouveau Système de Cotation).Google Scholar
  26. 26.
    The only exception is what is called hidden orders, i e limit orders which are only partially visible to the market participants.Google Scholar
  27. 27.
    Strictly speaking, the first information based model can be traced back to Bagehot (1971), but Glosten and Milgrom (1985) first introduce the key idea that trades reveal informed traders private information, which has become the hallmark of these models.Google Scholar
  28. 28.
    lntraday data are described closely in Chapter 3.Google Scholar
  29. 29.
    Thanks to the information models, volume and the much criticized technical analysis are found to have important implications on the behavior of the market makers. See for example Easley and O’Hara (1992) or Blume, Easley and O’Hara (1994).Google Scholar
  30. 30.
    As Brock and Kleidon (1992) show, information models have trouble explaining why both spread and volume are larger at the same period of the day. A high spread at the open can be due to the asymmetric information effect already mentioned, as market makers must take into account the overnight information. But that does not explain why most traders wish to transact at that time too. Liquidity traders in particular should avoid these trading periods because of the large spread.Google Scholar
  31. 31.
    The Consolidated Audit Trail Data is a proprietary database of the NYSE where audit trail records for shares traded on the NYSE are recorded.Google Scholar
  32. 32.
    More precisely, Engle and Russell (1998) introduce the autoregressive conditional duration model (ACD model) to deal with financial durations.Google Scholar

Copyright information

© Springer Science+Business Media Dordrecht 2001

Authors and Affiliations

  • Luc Bauwens
    • 1
  • Pierre Giot
    • 1
    • 2
  1. 1.Université Catholique de Louvain (CORE)Belgium
  2. 2.University of MaastrichtThe Netherlands

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