Market Microstructure

Overview


Market structure refers to the how markets are organized in order to bring buyers and sellers together, and the mechanisms used to execute transactions. The structure of a market can have an impact on the price that a trader receives when executing trades.

Trader Types


In order to understand how a market functions and what drives the price dynamics, one must understand the players who interact in that market.

  • Buy Side
    • Investment Sponsors: are institutions that manage large investment porfolios which would include pensions, mutual funds and endownments.
    • Retail Traders: individual traders that trade for their account.
  • Sell Side
    • Dealers: are institutions that manage large investment porfolios which would include pensions, mutual funds and endownments.
    • Day Traders:
    • Brokers

Market Structures


  • Exchanges: were physical locations where traders could gather to trade the assets that the exchange supported. Today, most exchanges are implemented electronically. Traders can still post the types of trades that they would be willing to execute, and the exchange matches buyers and sellers according to a set of rules established by the exchange.
  • Electronic Communications Networks (ECN): are privately owned electronic exchanges that are not regulated as an exchange. Usually owned by brokers or dealers.
  • Dark Pools: is an electronic exchange that is not generally open to the public, and does not make its order book public. This is done so that traders in the pool can trade large blocks without tipping the market to their trade.
  • Over the Counter (OTC): refers to private trades between a agent and a dealer. The agents trades do not become public information. OTC trades are necessary for trades with custom terms, such as derivatives for which there is no common market.

Trade Facilitators


  • Clearing Agents: matches the records from traders at an exchange in order to confirm the details of a trade. Clearing is not required for automated order matching systems.
  • Settlement Agents: facilitate the settlement of trades. A settlement agent receives the securiities and cash from the traders involved in a trade. After receipt, the settlment agent then sends the securities and cash to the relevant party. This solves the problem of a trader parting with a security or cash prior to receiving the other.
  • Clearinghouse: is a single settlement agent that is associated with a given exchange. Clearinghouses will also guarantee trades, meaning that they will make whole any trade for which one party is delinquent.
  • Custodian: holds cash and secuirities on behalf of its clients. The DTC (Depository Trust Company) is the largest custodian in the United States.

Order Book and Order Types


When a trader decides to trade, she places instructions for her trade to the order book of the exchange where she is trading. Orders are structured and matched to orders from other traders based on the rules set up by the exchange. The order specifies the security to be traded, whether to buy or sell, and then some indication as to the price that the trader is willing to trade at.

  • Market Order:
  • Limit Order:

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