What is Financial Market Microstructure?
Market microstructure is all about the core of how financial markets operate. It explains the process of trading financial assets on various exchanges works, as well as the characteristics of price discovery, which is usually very similar across exchanges.
Other topics explored in the the topic of market microstructure include:
- The structure of trading exchanges
- The process of price discovery
- The various factors that determine the Bid-Ask spread
- The behaviour of market participants engaged in intra-day trading
- Transaction costs
With the rapid advancement in technology, the overall market microstructure has evolved with the rapid influx of trading algorithms that have taken a larger portion of the overall market volume, significantly dominating in some markets. This latest trend of the past few decades is another reason for serious market participants to understand financial market microstructure, along with the absolute necessity for understanding order flow.
To buy and sell financial securities, it is necessary to have a centralized venue to transact with other participants.This is where the exchange comes in—an electronic market that connects buyers and sellers with precise rules for matching orders.
Besides settling the trade transactions transparently and efficiently, exchanges also often promote liquidity with market maker mandates or commission rebates to ensure there are always bids and offers for the securities.
Price discovery is the mechanism that is the balancing act of matching the market’s constantly shifting supply and demand for an asset. The interaction between buyers and sellers is what creates a price in the first place.
Elements of Price Discovery
The market price of financial securities is influenced by several factors, including:
- Supply and demand for the asset or security
- The risk appetite of market participants
- The level of existing volatility in the market
- The availability of critical information (such as news or central bank data), which have a large impact on market sentiment
What Is Liquidity In Financial Markets?
Financial market liquidity is how much buying and selling power is available on the market—the market depth. A market is highly liquid if it possesses large trading volume, and the securities can be traded quickly and at size with little to no impact on price.
A highly illiquid market, on the other hand, often means prices are more volatility and that the price you see isn’t necessarily the price you get.
This can be further understood by exploring the concepts of bids, offers, and the various order types available in the market.
Bids and Offers
Financial markets are almost always a dual-auction process. This is achieved by having liquidity on both sides of the market:
- Bid price: The maximum price that a buyer is willing to pay to buy a security
- Offer price: The lowest price that a seller is willing to sell a security
The difference between the bid and offer is called the spread. Usually, a lower spread implies a more liquid market, but this isn’t necessarily always true.
Every financial market is based upon 3 very simple order types, although each individual exchange may have tens more variations, and their simple interactions can be quite complex.
Here are the 3 main building blocks of every exchange.
- Market Order: This order tells the exchange “I want to buy/sell the security right now, at any price”.
- Limit Order: This order tells the exchange “I want to transact at only this price or better”. In the case of a sell limit, it will be the specified price or higher, and with a buy limit, the specific price or lower.
- Stop Order: Often used for getting out of losing positions as a risk management tool, it allows the trader to specify the price—that if traded—will execute a market order.
Most Common Market Participants
Each market has many different market participants. These usually consist of the following:
- Hedgers: These players usually trade in futures, forwards, and options, in an attempt to offset their risk in other markets. For example, airline companies will hedge oil prices so they can more consistently price their flight costs.
- Speculators: These are the traders and investors of the market that take long and short positions based on pattern-recognition and other forms of analysis. Speculators can be algos, individual traders, or large institutions such as hedge funds.
- Market makers v/s Market takers: In every securities market, the market makers and takers exist in a symbiotic relationship. They both depend upon each other to fulfil their intent and purposes.
- A market maker maintains the spread by providing liquidity, looking to profit from high-volume transactions or a wide spread.
- A market taker provides a sort of price check, keeping prices aligned with the fundamentals or technicals.
Before making a trade, it is important to understand how the market functions. An understanding of exchanges, order types, and market participants is essential knowledge to make yourself into a successful trader.
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