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2017 | OriginalPaper | Chapter

10. Security Market Microstructure: The Analysis of a Non-frictionless Market

Authors : Reto Francioni, Sonali Hazarika, Martin Reck, Robert A. Schwartz

Published in: Equity Markets in Transition

Publisher: Springer International Publishing

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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.

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For a recent discussion, see Davis et al. [72].

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

Two further assumptions are required to obtain (10.3): (1) the third derivative of utility with respect to wealth is small enough to ignore; and (2) the squared deviation of the expected rate of return on the risky asset from the risk-free rate is small enough to ignore.

Another major issue addressed by the microstructure literature at that time was the impact of information on trading volume and price ([74‐76]).

For further discussion, see Cohen et al. [5].

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.

Cohen et al. [35] describe the trade-off between execution probability and price improvement in the optimal choice between limit and market orders.

See Back et al. [77] for a recent discussion and further references.

See Economides et al. [78] for a description of alternative call market structures.

Trading systems differ in their degree of transparency Pagano et al. [79] investigate whether greater transparency enhances market liquidity by reducing the opportunities for taking advantage of uninformed participants.

Also see Hasbrouck, Joel. “One security et al. [65], Harvey et al. [80], and Jones et al. [81].” Further references are provided by Menkveld et al. [55].

Also see Bessler, Wolfgang. Editor, Bösen et al. [82] for discussion and further references.

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

Further discussion of market structure development is provided by Harris and Larry. Trading and Exchanges: Market Microstructure for Practitioners [89].

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

For further discussion and descriptions, see Francioni et al. [1].

Appendix 2 provides details of Xetra’s design.

Interestingly, the microstructure literature on call auctions was relatively sparse at that time. For an early discussion, see Handa et al. [90].

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Title: Security Market Microstructure: The Analysis of a Non-frictionless Market
Authors: Reto Francioni
Sonali Hazarika
Martin Reck
Robert A. Schwartz
Publisher: Springer International Publishing
Book: Equity Markets in Transition
Print ISBN: 978-3-319-45846-5

Electronic ISBN: 978-3-319-45848-9

Copyright Year: 2017
DOI: https://doi.org/10.1007/978-3-319-45848-9_10