What is Market Microstructure?
Market microstructure is the study of financial markets and how they work. According to the National Bureau of Economic Research (NBER), market microstructure focuses on theoretical, empirical, and experimental research on the economics of security markets. Essentially, market microstructure helps traders and portfolio managers what makes market participants tick.
The term was coined by UC Berkeley Professor Mark Garman in 1976 to describe the minute trading activity in asset markets. This field of research is vital to traders as it plays a key role in algorithmic and electronic trading. In a perfect market, equilibrium prices would reflect the demand from all potential investors. But because of the complexity and multifaceted markets of today, prices tend to deviate from equilibrium values and other traditional economic theories.
With the level of trading volumes skyrocketing and evolving trading processes, market microstructure analysis is largely concerned with understanding the ever-changing marketplace. It’s used to capture the best possible market prices so traders and portfolio managers are able to improve their portfolio returns. At Quantitative Brokers, our market microstructure expertise is deeply integrated in the genetic makeup of our algorithm suite.
The market microstructure is composed of a few key elements, largely dealing with how information is conveyed in price movements, liquidity, and transaction costs, in other words big data. These elements provide valuable insight for any algorithmic trading on the state of the market during a set time. For example, understanding the bid-ask spreads and volatility over time can give a trader insight into how the market is responding to economic and political events.
Understanding these types of microstructures is at the heart of asset pricing, driving many trading and investment opportunities and decisions. This data also provides fair and transparent data to make quick trades. In algorithmic trading, market microstructure supplies the necessary data to our technology infrastructure to respond in real-time, based on tailor-made response design. Because of the friction in the markets, it’s important for market microstructure analysis to fully understand not only price discovery and market liquidity, but how prices and trading behaviors could change with new information and decisions.
With advances in technology, the market is no longer simply a group of traders on an exchange floor, quoting bid-ask prices. The market microstructure of today’s trading world is far more complex, with various trading venues, electronic crossing networks, alternative trading systems, and varying degrees of complex algorithms. To make it even more complicated, each comes with its own rules of engagement, resulting in different queuing and pricing models, such as maker-take, inverted, commission based, price-time, and more.
As a result of these constantly changing dynamics, it’s important to have in-depth market microstructure analysis that can describe specific features like trading volume, volatility, and the spread on trade duration. (Check out our report on this here!) Having a profitable trading algorithm is reliant on traders having a full understanding of the inner workings of the market microstructure and how these nuances affect their orders.
The reports provide valuable information to traders and portfolio managers to help them capture market prices, which in turn can help reduce performance drag. We cover a number of metrics for various assets, such as volatility, liquidity, spread, quote size, and more. Drastics changes in the microstructure market can lead to execution slippage. Our reports aid in slippage attribution, facilitate execution costs, and help determine potential market regimes.
At Quantitative Brokers,market microstructure is at the center of our algorithm design. We use it in our trading and decision-making process, analyzing, comparing and building upon their evolvement. We support our clients, helping them detect and navigate regime changes to the world’s largest global markets across futures, US treasury and options markets. But don’t just take our word for it; see it for yourself.
Quantitative Brokers
November 2022
New York, NY