Is the Market Microstructure of Stock Markets Important?

Abstract

The market microstructure literature studies how the actual transaction process – i.e. how buyers and sellers find one another and agree on a price – can affect price formation and trading volumes in a market. This article provides an introduction to the concepts, frameworks and most important themes in this literature. The market serves two functions: one is to provide liquidity for buyers and sellers; the other is to ensure that prices reflect relevant information about fundamental value. Microstructure models differ from traditional financial models by recognising that legitimate information about companies’ fundamentals may be unequally distributed between, and differently interpreted by, market participants. We can therefore no longer assume that prices will reflect information immediately even if all participants are rational. The microstructure literature argues that both information risk due to asymmetric information and differences in liquidity over time and between companies impact on long-term equilibrium prices in the market.