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bias-spatt-survey - Market Microstructure: A Survey of...

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Unformatted text preview: Market Microstructure: A Survey of Microfoundations, Empirical Results, and Policy Implications Bruno Biais, Larry Glosten and Chester Spatt* Abstract We survey the literature analyzing the price formation and trading process, and the conse- quences of market organization for price discovery and welfare. We o&er a synthesis of the the- oretical microfoundations and empirical approaches. Within this framework, we confront adverse selection, inventory costs and market power theories to the evidence on transactions costs and price impact. Building on these results, we proceed to an equilibrium analysis of policy issues. We re- view the extent to which market frictions can be mitigated by such features of market design as the degree of transparency, the use of call auctions, the pricing grid, and the regulation of competition between liquidity suppliers or exchanges. *Biais is from Toulouse University, Glosten is from Columbia University, and Spatt is from Carnegie Mellon University. We are grateful for helpful comments from Peter Bossaerts, Cather- ine Casamatta, Thierry Foucault, Ravi Jagannathan, Maureen OHara, Christine Parlour, Patrik Sandas and Avanidhar Subrahmanyam. 1 The Microstructure of Stock Markets Mark Garman (1976) quite aptly coined the phrase \market microstructure" as the title of an article about market making and inventory costs. The phrase became a descriptive title for the investigation of the economic forces a&ecting trades, quotes and prices. Our review covers not only what research has had to say about the nature of transaction prices, but also the broader literature on the interrelation between institutional structure, strategic behavior, prices and welfare. In perfect markets, Walrasian equilibrium prices reect the competitive demand curves of all potential investors. While the determination of these fundamental equilibrium valuations is the fo- cus of (most) asset pricing, market microstructure studies how, in the short term, transaction prices converge to (or deviate from) long{term equilibrium values. Walras himself was concerned about the convergence to equilibrium prices, through a t^ atonnement process. One of the rst descriptions of the microstructure of a nancial market can be found in the Elements dEconomie Politique Pure (1874), where he describes the workings of the Paris Bourse. Walrass eld observations contributed to the genesis of his formalization of how supply and demand are expressed and markets clear. 1 Market microstructure o&ers a unique opportunity to confront directly microeconomic theory with the actual workings of markets. This facilitates both tests of economic models and the development of policy prescriptions....
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bias-spatt-survey - Market Microstructure: A Survey of...

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