Security Market Microstructure: Theory and Practice

Author: Liu Ti
Publisher:
Publish Date: 2002-11-01
Features: Preface
Market microstructure theory, also known as market microstructure economics, is a significant branch of finance that studies the process of price discovery and the mechanisms of trading. It is also one of the fastest-growing branches in finance. As a cutting-edge field in modern finance, the theory of market microstructure in securities markets has garnered increasing attention from scholars and industry professionals. Market microstructure theory emerged in the late 1960s. Demsetz's 1968 paper, "The Costs of Transacting," marked the birth of market microstructure theory. However, it achieved rapid development and truly became a "field of prominence" after the 1987 global stock market crash. The extreme volatility of the stock market exposed the fragility of securities markets while also strengthening investors' risk awareness, prompting scholars to begin in-depth discussions on how to establish sound and reasonable trading mechanisms—a pressing issue.
After Demsetz's classic paper, the development of ideas on market microstructure began to focus on the quoting behavior of market makers, gradually forming two main approaches: the inventory-based model and the information-based model. The inventory model, also known as the complete information trading model, assumes the existence of an optimal inventory level for market makers. Therefore, market makers only need to adjust prices or spreads based on order flow to maintain this optimal inventory level. The information model primarily examines the impact of information asymmetry on market prices. This model categorizes traders into informed traders and liquidity traders, arguing that prices are influenced not only by inventory costs but, more importantly, by information asymmetry.
Market microstructure theory mainly includes two categories of content: one is models and empirical research on price discovery, and the other is theoretical and empirical research on market structure and design. Entering the 20th century...