Market microstructure: A survey of microfoundations, empirical results, and policy implications

Abstract

We survey the literature analyzing the price formation and trading process, and the consequences of market organization for price discovery and welfare. We offer a synthesis of the theoretical 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 review 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. r 2005 Published by Elsevier B.V. 0. Introduction 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 affecting trades, ARTICLE IN PRESS www.elsevier.com/locate/econbase 1386-4181/$ -see front matter r 2005 Published by Elsevier B.V.

Trading frequency and asset pricing on the London Stock Exchange: Evidence from a new price impact ratio

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