Market Microstructure

The Foundation to Understanding What’s Under the Surface

One of the primary purposes of financial markets is to provide liquidity.

When a market is liquid, trades can be made without affecting prices too much. There are four ways to measure liquidity:

• Immediacy: How quickly orders can be filled and at what cost.

• Depth: The number of units available for a given price.

• Breadth or width: The cost per unit of liquidity, which is often measured by the bid/ask spread.

• Resiliency: How quickly prices return to normal after large trades from uninformed traders.

The types of orders in a market also affect liquidity. Limit orders provide liquidity by setting the values for market orders, while market orders take liquidity because they demand immediate trades. As more limit orders are entered into the system, liquidity builds up. Other types of orders, such as Market-if-touched and undisplayed orders, also contribute to liquidity.

As already mentioned suppliers of liquidity include fundamentally dealer/market makers and arbitrageurs.

It is crucial to understand that the roles in the market are not predetermined and that in certain markets, certain actors may not be present, whereas in others, they may have a different role.

In order to simplify an understanding of this concept, it is advisable to examine the market microstructure.

1. Quote driven market: The market microstructure of:

   • bonds

   • currencies

   • commodities (cash, not derivatives)

   • OPTIONS

   A market maker will either fill the order from their inventory or match it with another order. Investors may attempt to negotiate better prices, either independently or through a broker or agent, however, the order will not be publicly posted. 

   Market makers have privileges, granted to them by regulations, to fulfill their duties in the market.

   The term "quote-driven market" describes a market where dealer quotes exclusively determine prices. These markets are also referred to as dealer markets and market maker markets.

   Dealers operate on OTC markets, while market makers operate on regulated markets.

   In a pure quote-driven system, dealers supply all the liquidity¹.

2. Order-Driven Market: Order-driven markets are different from quote-driven markets. In order-driven markets, buyers and sellers trade with each other through the exchange, without the intermediation of Market maker. Trading rules are in place to arrange trades, including order precedence rules and trade pricing rules. Auction markets are the most common type of order-driven market, where buyers seek the lowest prices and sellers seek the highest prices. Through the Depth of Market screen, all participants have visibility to the same order book, and all orders are queued at one exchange through a Central Limit Order Book (excluding block trades).

   Order-driven markets, despite their operational differences, adhere to a set of common trading rules. Traders are matched with others based on the sequence and pricing of orders. These markets have built-in safeguards to ensure that all participants are reliable and financially sound.

   There may be dealers/MM trading in order-driven markets, but they trade on an equal basis with all other traders².

   Order-driven markets can have excellent properties, particularly for liquid instruments, but they may have problems with illiquidity for mid- and small-cap stocks. This can disrupt price discovery and trading when large orders are involved.

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   This type of market is more suitable for financial instruments such as futures, which offer greater flexibility in terms of liquidity due to the presence of open interest³.

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3. Hybrid Market: Consequently, equities trade in a hybrid market that is structured as a combination of quote-driven and order-driven. The New York Stock Exchange (NYSE) is the most famous hybrid market.

   The market makers in the regulated stock market are responsible for maintaining the bid-ask spread within a specific limit.

   There is a fourth type of market structure:

4. Brokered Market: In a brokered market, brokers help their clients find a counterparty that is willing to execute a trade. Brokered markets are primarily used for unique and/or illiquid assets, such as real estate, antiques, large blocks of shares, etc. Such assets attract limited buyers/sellers and are not sufficient for dealers to create a market with them.

image by Gianni Berardi

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Next time, I will delve into the structure of the E-mini S&P 500 futures market, which is an order-driven market regulated by the CME, and I’ll demonstrate that market makers have no role in it, except for block trades. On the other hand, I’ll also demonstrate that SPX options are traded in a quote-driven market.

So that I’ll prove the statement above: in certain markets, certain actors may not be present, whereas in others, they may have a different role.

1. The infamous CFD are traded in a “quote-driven way”

2. More on this in the next episode

3. Eminisp500 futures are, in fact, traded in an order-driven market