1 Works Cited

CFA Institute Centre for Financial Market Integrity. (2009). Market Microstructure:The
Impact of Fragmentation under the Markets in Financial Instruments
Directive. CFA Insitute.
Ekkehart Boehmer, G. S. (2005). Lifting the Veil: An Analysis of Pre-trade
Transparency at the NYSE. THE JOURNAL OF FINANCE VOL. LX, NO. 2, 783815.
Fama, E. (1970). Efficient Capital Markets:A Review of Theory and Empirical Work.
Journal of Finance, 383-417.
Flood, M. D. (1991, November). Microstructure Theory and the Foreign Exchange
Market. 52-68. Federal Reserve Bank of St. Louis.
Frank Fabozzi, F. M. (1996). Capital Markets Instituitions and Instruments. New
Jersey: Prentice Hall.
Madhavan, A. (2000). Market microstructure: A survey. Journal of Financial Markets,
205-258.
Marco Cipriani, a. A. (2007). TRANSACTION COSTS AND INFORMATIONAL CASCADES
IN FINANCIAL MARKETS. Frankfurt: EUROPEAN CENTRAL BANK.
O'Hara, M. (1998). Market Microstructure Theory. John Wiley & Sons.
Reto Francioni, S. H. (2008). Equity Market Microstructure:Taking Stock of What We
Know. THE JOURNAL OF PORTFOLIO MANAGEMENT, 57-71.
Shimizu, J. M. (1999). Market microstructure and market liquidity. Japan: Bank for
International Settlements.
Stoll, H. R. (2002, May 6). Market Microstructure. Handbook of the Economics of
Finance, pp. 1-64.
Thierry Foucault, M. P. (2013). Market Liquidity - Theory, Evidence, and Policy.
Oxford: Oxford University Press.

Abstract
This paper reviews literature on market microstructure. Microstructure analysis gives guidance to
market structure development, facilitates the development of trading strategies, there are tests of
market efciency and it also sheds light on how new information is incorporated into securities
prices. The critical factor that drives microstructure analysis is friction in the marketplace (i.e.
the various market imperfections that affect price formation, liquidity and the speed of price
discovery).

INTRODUCTION
Rapid structural technological and regulatory changes affecting the securities industry
worldwide have compelled interest in market microstructure. These changes are due to factors
including but not limited to substantial increase in trading volumes, competition between
exchanges, modifications in the regulatory environment, technological innovations as well as
globalization and the advent of new financial instruments.
In this literature review, we seek to highlight and understand the applications of market
microstructure. Briefly, microstructure analysis gives guidance to market structure development,
facilitates the development of trading strategies, tests market efciency and also sheds light on
how new information is incorporated into the prices of securities (Reto Francioni, 2008).
2

MARKET MICROSTRUCTURE
The study of the process and outcomes of exchanging financial assets under a specific set

of rules refers to market microstructure (O'Hara, 1998). It is concerned with the behavior of
participants in securities markets and with the effects of information and institutional rules on the
economic performance of those markets (Flood, 1991). Key issues such as trading costs,
transparency, price formation, and market design are addressed (CFA Institute Centre for
Financial Market Integrity, 2009).
Microstructure analysis is inherently involved with analyzing the detailed functioning of
a marketplace. The literature on this subject examines the structural factors that determine the
process of financial intermediation. These structural factors, which determine how prices and
volumes reveal investor preferences, are crucial to the efficient functioning of markets.
In a survey of market microstructure (Madhavan, 2000), the writer contends that studies
on the subject fit into four categories. First, price formation and price discovery, which
investigates how prices and volumes incorporate latent demands of investors, including
investigation of determinants of trading costs and processes of how prices embody information.
Second, market structure and design issues, which concern the relationship between price
formation processes and trading rules. Third, information and disclosure, which assumes that the

behaviors of traders are affected by the 1black box. Finally, informational issues arising from
the interface of market microstructure with other areas of finance, such as corporate finance,
asset pricing, and international finance.
2.1

Main issues of market microstructure

The study of market microstructure addresses two key aspects of markets,
liquidity and price discovery. The theoretical issues we identified are how markets are
organized, how various market imperfections affect price formation, liquidity and the
speed of price discovery (informational efficiency), how market liquidity is measured, and
the relative importance of various determinants of liquidity and how key features of market
design affect the level of liquidity and price discovery.
1.1.1. Market Liquidity
Liquidity is the degree to which an order can be executed within a short time
frame at a price close to the securitys consensus value. Conversely, a price that
deviates substantially from this consensus value indicates illiquidity: in an illiquid
market, buy orders tend to push transaction prices up, while sell orders tend to do
the opposite.
Liquid markets enable people to fund investments that require long-term
commitment of wealth, while retaining the opportunity to access that wealthwhen
needed.

In this way, liquidity facilitates real investment and enhances

economic growth (Thierry Foucault, 2013).

Liquidity is important as it affects return on investments. Illiquid securities
cost more to buy and sell for less. Analysis of liquidity therefore informs decisions
on portfolio management. It is also of importance to those providing trading
services for locating liquid trading venues or timing, to minimize costs, which is
ideal for good service.
Liquidity can also vary with time and with such uncertainty, investors will
require compensation for the additional risk, affecting the return on investment.

1 The black box here refers to situation in which investors have knowledge of their
inputs (such as orders) and outputs (such as prices and volumes), but without any
knowledge about the internal formation process.

1.1.2. Price Discovery

This is the speed and accuracy with transaction prices embody information
available to market participants. The reliability of securities prices is a reference
point for investment decisions as well as a benchmark for evaluating management
performance. Additionally, the need to compensate investors for illiquidity creates a
link between the field of market microstructure and that of asset pricing. Illiquidity
lowers securities prices, affecting the cost of capital for the issuers.
2.2

Theoretical Issues of Market Microstructure

These relate to how various market imperfections affect price formation, liquidity and
the speed of price discovery.

2.2.1

Market Structure - How Markets Are Organized

Market design affects trading costs and price discovery. Securities markets
are facilities for bringing buyers and sellers together and enabling them to trade.
The need to mitigate risks (hedging), the desire to exploit superior information
(speculation), or the urge to rebalance ones portfolio prompts trading.
A trading mechanism defines the rules of engagement that these market
participants must follow in so doing. It determines the actions they can take (e.g.,
the kinds of orders they can place), their information about other market
participants actions (e.g., whether they observe quotes or orders), and the
protocol for matching buy and sell orders (Thierry Foucault, 2013).
All trading mechanisms can be viewed as variations of

two

basic

structures, namely the limit order market (or auction market) and the dealer
market. In limit order markets, the final investors interact directly, their bids and
offers consolidated in a limit order book, according to price priority, so that higher
bids and cheaper offers are more likely executed.
By contrast, in dealer markets final investors can only trade at the bid and
ask quotes posted by specialized intermediaries, called dealers or market makers,

and these quotes are not consolidated to enforce price priority (Thierry Foucault,
2013). Most real-world markets are a mixture of market types.
The two main roles of a securities market are to provide trading services
for investors and to determine prices that can guide the allocation of capital by
investors and firms. That is, an ideal market structure facilitates efficiency,
enabling investors to trade quickly and cheaply and it incorporates new
information quickly and accurately into prices.
2.2.2

Information efficiency

Microstructure analysis includes tests of market efciency. Depending on the

content of information assimilated in the current value of a security, three forms of
pricing efficiency are apparent (Fama, 1970). The distinction between these forms lies in
the relevant information, held evident in the price of a security. Weak efficiency means
that the price reflects the past price and trading history. Semi-strong efficiency means that
it fully reflects all public information. Strong efficiency exists in a market where the price
reflects all information, whether publicly or privately held.

2.2.3

Market Transparency
Information efficiency has implications on market transparency. The amount of

trading information available to participants determines a markets degree of

transparency. This information matters to traders, as it enables them to sharpen their
estimates of securities values and devise better trading strategies. Transparency
depends on not only the availability but also the cost of information. Transparency also
affects market liquidity (Ekkehart Boehmer, 2005).
A price-efficient market has implications for the investment strategies investors
may wish to follow. Microstructure tests of pricing efficiency investigate whether it is
possible to generate abnormal returns.
2.2.4

Transaction costs

They consist of brokerage commissions, fees and opportunity costs. Commissions

are charges levied by brokers to trade securities on behalf of investors whereas fees could
relate to charges by an institution for custodial service or transfer of financial assets. The
cost of not transacting represents an opportunity cost, arising from non-execution of
desired trades (Frank Fabozzi, 1996).
Transaction costs (e.g., a trading fee or a transaction tax) have effects on the
aggregation of private information in financial markets. Some have argued that
transaction costs impair the process of price discovery and reduce the informational
inefficiency of markets. Others have pointed out that they help to stabilize markets and to
prevent the occurrence of financial crises, by reducing the incentives for speculative
trading.
Studies show that the presence of transaction costs has a significant effect on the
ability of the price to aggregate private information dispersed among different agents.
Transaction costs cause informational cascades, i.e., situations in which all informed
traders neglect private information and abstain from trading (Marco Cipriani, 2007).

THE TRADING PROCESS

The elements of the trading process are into four components - information, order

routing, execution, and clearing. First, a market provides information about past prices and
current quotes. Second, a mechanism for routing orders is required. Brokers take orders and
route them to an exchange or other market center. The third phase of the trading process is
execution. This is matching an incoming market order with a resting quote. It can be either
dealer-initiated or automated. The trend is towards automated execution systems.
The last phase of the trading process is clearing and settlement. Clearing involves the
comparison of transactions between buying and selling brokers. These are daily comparisons. In
Kenya, the settlement cycle takes place at day t+3, with the cash side of the settlement process
for transactions concluded on the Nairobi Securities Exchange (NSE) done through the Central
Bank of Kenyas (CBK) Real Time Gross Settlement (RTGS) system and the securities leg of the
settlement process, which entails the transfer of securities between the buyers and sellers, is
carried out at the Central Depository and Settlement Corporation (CDSC).

4 Bibliography
CFA Institute Centre for Financial Market Integrity. (2009). Market Microstructure:The
Impact of Fragmentation under the Markets in Financial Instruments
Directive. CFA Insitute.
Ekkehart Boehmer, G. S. (2005). Lifting the Veil: An Analysis of Pre-trade
Transparency at the NYSE. THE JOURNAL OF FINANCE VOL. LX, NO. 2, 783815.
Fama, E. (1970). Efficient Capital Markets:A Review of Theory and Empirical Work.
Journal of Finance, 383-417.
Flood, M. D. (1991, November). Microstructure Theory and the Foreign Exchange
Market. 52-68. Federal Reserve Bank of St. Louis.
Frank Fabozzi, F. M. (1996). Capital Markets Instituitions and Instruments. New
Jersey: Prentice Hall.
Madhavan, A. (2000). Market microstructure: A survey. Journal of Financial Markets,
205-258.
Marco Cipriani, a. A. (2007). TRANSACTION COSTS AND INFORMATIONAL CASCADES
IN FINANCIAL MARKETS. Frankfurt: EUROPEAN CENTRAL BANK.
O'Hara, M. (1998). Market Microstructure Theory. John Wiley & Sons.
Reto Francioni, S. H. (2008). Equity Market Microstructure:Taking Stock of What We
Know. THE JOURNAL OF PORTFOLIO MANAGEMENT, 57-71.
Shimizu, J. M. (1999). Market microstructure and market liquidity. Japan: Bank for
International Settlements.
Stoll, H. R. (2002, May 6). Market Microstructure. Handbook of the Economics of
Finance, pp. 1-64.
Thierry Foucault, M. P. (2013). Market Liquidity - Theory, Evidence, and Policy.
Oxford: Oxford University Press.