1 Introduction

1.1
Scope of the Book
- Market Microstructure
o Branch of financial economics that investigates trading and the
organization of markets
o Field has substantially grown in size and importance since 1987 crash
1.2
Objectives
1.3
Instruments and Markets
- Instruments
o Common stocks, preferred stocks, bonds, convertible bonds, warrants,
options, futures contracts, forward contracts, foreign exchange
contracts, swaps, reinsurance contracts, commodities, pollution
credits, water rights, and even many betting contracts, etc
o Used to examine organized trading
- Markets
o The place where traders gather to trade instruments
Physical trading floor
NYSE
Chicago Mercantile Exchange
EuroNext Amsterdam Options Exchange
Electronic system where traders can easily communicate with
each other
Nasdaq
EuroNext
Hong Kong Futures Exchange
Interbank foreign exchange market
1.4
A Brief Overview of Trading and Exchanges
- Quantities
o Traders have to find enough people willing to trade with them
- Sizes
o see Quantities
- Dealers
o Trade with their clients when their clients want to trade
- Bid
o Price at which dealer will buy from clients
- Ask
o Price at which dealer will sell to clients
- Brokers
o Agents who arrange trades for their clients
o Help clients find traders willing to trade with them
o Profit by charging commissions
- Speculators
o Traders who trade to profit from information they have about future
prices
- Well-informed speculators
o Able to predict futures prices better than other traders
o Choose to buy or sell based upon which side they expect will profit
o Often beat dealers

1.5
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Bluffers
o People who fool uninformed traders into trading unwisely
o Able to profit if price impacts of their buying and selling are not exactly
opposite to each other
Zero-sum game
o Someone can win only if somebody else loses
Investors
o Use the markets to move money from the present to the future
Borrowers
o Use markets to move money from future to present
o Opposite of investor
Hedgers
o Trade to manage financial risks they face
Asset exchangers
o Trade one asset for another they value more
Gamblers
o Trade to entertain themselves
Arbitrageurs
o Ensure that prices do not vary much across markets
o When prices diverge, they buy in cheaper markets and sell in more
expense markets
o Connect sellers in cheaper markets to buyers in more expensive
markets
Fungible
o If one unit (a share, bond, contract, etc) of the instrument is
economically indistinguishable from all other units
o Easier to trade since buyers dont care which units they receive, and
will buy best price, and sellers can sell to any buyer
o Easier to trade that instruments with idiosyncratic characteristics
o In derivative markets, cause trading to concentrate in just a few
standardized contracts
Key Recurrent Themes
Information Asymmetries
o Traders who know more about values and traders who know more
about what other traders intend to do have a great advantage over
those who do not
o Well-informed traders profit at the expense of less-informed traders
Options
o The option to trade
o People who write limit orders give free trading options to other traders
Externalities
o positive externalities
created when people do something that benefits other people
without compensation
o negative externalities
created when people do something that harms other people
without penalty
order flow externality

most important externality in market microstructure

traders who offer to trade give other traders valuable options to
trade for which the offerers are not compensated
attracts and binds traders to markets because they want to
benefit from free trading options
market structure
o consists of the trading rules, the physical layout, the information
presentation systems, and the information communication systems of
a market
o determines what traders can do and what they can know
o affects trader strategies, the power relationships among different types
of traders, and ultimately trader profitability
Competition with free entry and exit
o Traders compete in markets to make profits
o Strategies with strategies generating large profits attract traders
o Strategies that are unprofitable are abandoned
o Ensures alternative trading strategies produce equal net profits, on
average, after accounting for all costs
Communications and computing technologies
o Markets are information processing mechanisms
Process information about who wants to trade, how much, and
at what prices
Resulting prices aggregate information about fundamental
values
Price correlations
o Markets for similar instruments are closely related
o Tend to have similar conditions and compete fiercely with each other
for order flow
Principal-agent problems
o Arise when agents do what they want rather than what their principals
want them to do
o Involves brokers and clients
Brokers wont always do what you want them to (may not work
as hard as you want them to)
Trustworthy
o People who try to do what they say they will do
Creditworthy
o People who can do what they say they will do
Zero-Sum game
o Accounting gains by one side must equal the losses suffered by the
other side
Outline of the Book
Bull markets
o Risking markets
o Bull use horns to thrust upwards
Bear markets
o Falling markets
o Bears strike downward with claws
o

1.6
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1.7
1.8
-

An Important Disclaimer
Summary
Understand theory and practice of trading in exchange markets and dealer
networks
- Markets have changed substantially the last 100 years, and will continue to
for the next 100
- Current pace of change is fast, and accelerating
- Economic principles governing markets and traders, however, will not
2 Trading Stories
2.1
A Retail Trade in an NYSE-Listed Stock
- Market order
o Instructs broker to buy at the best price available
- Limit order
o Instructs broker to buy at the best price possible, but in no event pay
more than limit price
o Include when order expires
- Limit price
o Price at which buyer instructs broker to not go above when buying
- Day order
o Order that will expire when the day trading session ends
2.2
A Retail Trade in a Nasdaq Stock
2.3
An Institutional Trade in a NYSE Stock
2.4
An Institutional Trade in a Nasdaq Stock
2.5
A Very Large Block Stock Trade
2.6
Some Cash Commodity and Associated Futures Market Trades
- Exchange for physical
o
- Cash exchange
o
2.7
An Options Market Trade
2.8
A Bond Market Trade
2.9
A Foreign Exchange Trade
3 The Trading Industry
3.1
Who Are the Players?
- Traders
o People who trade
o Arrange their own trades, have other arrange trades for them, or
arrange trades for others
- Proprietary traders
o People who trade for their own accounts
- Brokers
o People who arrange trades as agents for their clients
- Agency traders
o See Brokers
- Commission traders
o See Brokers
- Commission merchants
o See Brokers
- Proprietary trading

o Trading done by proprietary traders

Agency trading
o Trading done by brokers
- Long positions
o When traders own something
o Profit when prices rise
o Buy low sell high
- Short positions
o When traders have sold something that they dont own
o Hope prices will fall so they can repurchase at lower price to cover
their position
- Cover their positions
o When traders short a stock, then buy back at a lower price to return
borrowed stock
- Short sellers
o Traders who short stocks
o Sell high buy low
- Buy side
o Traders who buy exchange services
- Liquidity
o Ability to trade when you want to trade
o Most important service
- Sell side
o Traders who sell liquidity to the buy side
3.1.1 The Buy Side
- Investment sponsors
o Buy-side institutions such as pension funds, mutual funds, trusts,
endowments, and foundations that invest money
- Investment advisors
o People who manage investment sponsors
- Investment counselors
o See Investment advisors
- Investment managers
o See Investment advisors
- Portfolio managers
o See Investment advisors
- Buy side traders
o Traders employed by investment advisors who execute trading
decisions
- Beneficiaries
o People who benefit from investment sponsors
3.1.2 The Sell Side
- Sell side
o Side of the trading industry that includes dealers and brokers who
provide exchange services to the buy side
o Help buy-side traders trade when they want to
- Dealers
-

People who accommodate trades that their clients want to make by

trading with them when their clients want to trade
o Profit when they buy low and sell high
- Brokers
o People who trade on behalf of their clients
o Arrange trades that their clients want to make by finding other traders
who will trade with their clients
o Profit when their clients pay them commissions for arranging trades
- Broker-dealers
o Traders who both deal and broker trades
- Dual traders
o See Broker-dealers
- Wirehouses
o Large broker-dealers
o Refers to the telegraph
Broker-dealers who used telegraph collect orders from branch
offices in distant cities were able to expand businesses
substantially and greatly increase profit
o Ability to communicate quickly was, and IS, very important in the
trading industry
3.2
Trade Facilitators
3.2.1 Exchanges
- Exchanges
o Provide forums where traders meet to arrange trades
- Order-driven trading systems
o Exchanges that arrange trades by matching buy and sell orders
according to a set of rules
o Often use computers, clerks, or member-traders to process orders
o Essentially brokerages (arrange trades for their clients)
- Electronic communications network
o Order-driven trading systems that are not regulated as exchanges
o May be owned by brokerages, dealers, or other entities
o Most important: Island ECN, Instinet, REDIBook, Archipelago,
Bloomberg Tradebook
o Most in process of registering to become exchanges
- Over-the-counter
o Trading that does not take place at exchanges
3.2.2 Clearing and Settlement Agents, Depositories, and Custodians
- Clearing Agents
o Clearing agent
Matches buyer and seller records and confirms that both traders
agreed to the same terms
o National Securities Clearing Corporation
Largest securities clearing agency in the US
o Clears
When a buyer and seller both report that they traded with each
other, and reported terms of trade are identical
o Out-trades
o

When records do not match exactly, and the clearing agent

reports discrepancies to the traders, who have to resolve them
o Dont Know
See Out-trades
Settlement Agents (middlemen)
o Escrow agents
Settlement agents in the real estate markets
o Net settlement
For each client, the settlement agent nets the buys and sells in
each security to a single net security position
o Normal-way settlement
Occurs three business days after trades are arranged
o T+3
See Normal-way settlement
o Cash settlement
Special settlement instruction which occurs on the day of the
trade
Clearinghouses
o Clearinghouses
Clear and settle all trades in derivative contracts
Usually guarantee that both parties will perform on their
contracts
Act as buyer for every seller and seller for every buyer
Are the issuers and guarantors of their contracts
Generally owned by clearing members
o Clearing members
Clearinghouse owners who are jointly responsible for settling all
trades
o Margins
Collateral required by clearinghouses to secure their obligations,
provide timely information about their financial conditions and
their trading activities, and not exceed positions limits that the
clearinghouse establishes for them
o Variation margin
Ensure that the incentives to default on a contract do not grow
as prices move against a losing position
o Straddle
When a trader holds positions in two different types of
instruments
Risks offset each other so that combined position is less risky
than either position held alone
Consists of a position in a put and an offsetting position in a call
o Technically bankrupt
When traders no longer have enough wealth to settle their
trades
If positions dont change, traders actually become
bankrupt

Brazilian straddle
Often used when traders know that they are technically
bankrupt and have nothing to lose
Massively increase positions, so that if price changes, they can
escape financial problems. If prices change against them, those
who guarantee their trades suffer the losses
- Depositories and Custodians
Hold cash and securities on behalf of clients
Help settle trades by quickly delivering cash and security
certificates
Help ensure security of clients assets
o Depository Trust Company
Largest depository in the world
o Straight-through processing
Trading systems that fully automate the clearing and settlement
process
Cheap and minimizes potential for error
3.3
Trading Instruments
- Trading Instruments
o Securities, contracts, commodities, and currencies that traders trade
Include: real assets, financial assets, derivative contracts,
insurance contracts, and gambling contracts
- Financial Instruments
o Include financial assets, derivative contracts, and insurance contracts
3.3.1 Real Assets
- Real assets
o Include physical commodities, real estate, machines, patents, and
other ntellectual properties
o Include pollution credits
o Appear only on assets section of BS
- Pollution credits
o Right to emit a specified quantity of a given pollution
3.3.2 Financial Assets
- Financial assets
o Instruments that represent ownership of real assets and the cash flows
they produce
o Stocks and bonds (represent ownership of the assets of a corp)
o Include currencies warehouse receipts, and trust units
- Issuers
o Creators of all financial assets
Corporations issue stocks, bonds,and warrants
Governments issue currencies and bonds
Warehouses issue commodity receipts
Trusts issue trust units
- Primary markets
o Where issuers first create and sell issues
- Secondary markets
o Subsequent trading of issues after first sold
o

New issues
o Newly issued issues
- Seasoned securities
o Issues after being initially issued
- IPO
o Where primary trading in new equity issues happens
- Underwriters
o Help issuers sell their securities
o Broker-dealers at IBs who find buyers for securities
o Charge issuers fees for their services
- Best efforts offering
o Underwriter acts strictly as a broker
- Underwritten offering
o Underwriter guarantees the issuer an offering price
- Fixed-price open offering
o Underwriter sets a price and buyers subscribe to the offering
If oversubscribed, underwriter conducts a lottery to allocate
shares
- Spot markets
o Markets where commodities and currencies trade for immediate
delivery
- Forward markets
o Market where commodities and currencies trade for future deverly
- Futures markets
o See Forward markets
3.3.2.1
Definitions of Some Common Financial Assets
- Equities
o Stocks
Represent ownership of corporate assets, net of corporate
liabilities
Value depends on corporate asets, liabilities, and income
Depend on how well traders expect corporate managers will use
corp assets in the future
o Preferred stocks
Stocks that pay diviends at contractually specific rates
Must pay all accrued dividends on preferred stocks before
paying any dividends on common stock
o American depository receipts
Trust units that traders use to trade foreign stocks in US markets
Each trust holds only the stock of a single foreign company
Allow traders to avoid international settlement problems
o Exchange traded funds
Mutual funds that trade at exchanges
Mostly index funds trying to mimic returns of a market or
industry index
o Reast estate investment trusts
Trusts that own real estate

Securitize real estate to allow investors and speculators to trade

real estate interests like common stock shares
Securitizing
Allows investors and speculators to trade real estate interests
like common stock shares
Instruments
Bonds
Debt securities issued by corporations, governments, and
occasionally individuals
Created when debtors borrow money
Value depends on interest rates, issuer creditworthiness, assets
pledged as collateral, and attached options
Often quoted as percentage of par value
Straight bond
Bond that pays interest periodically until it matures
At maturity, issuer redeems bond for principal value
Principal
Price at which issuer redeems bond
Face value
See Principal
Credit quality
Probability that a bond issuer will make all bond payments when
they are due
Investment grade bonds
Bonds that are expected to make all interest and principal
payments on time
Junk bonds
Bonds with less certain interest and principal payments
High yield bonds
See junk bonds
Investors require high yields to compensate for probability that
issuers will default on their payments
Credit quality depends on financial strength of its issuer and
upon that collateral and bond covenants that the issuer uses to
secur the bond
Treasury bills
Debt securities issued by a country
Mature in one year or less
Dont pay interest
Sell at discount from face value
Treasury notes
See Treasury bills
Mature in 2-5 years
Treasury bonds
See Treasury bills
Mature ten or more years after issued
Zero coupon bonds

o
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Debt
o

o
o
o

o
o

o
o

o
o

o
o

o
o
o

Bonds that pay no interest

Simply return their principal value at maturity
Buyers only buy if at a discount from face value
Pure discount bonds
See Zero Coupon bonds
Fixed income arbitrageurs
Jump into action when zero-coupon bonds desired more than
available
Buy straight bonds and clip the coupons
Bundle coupons by interest payment dates and sell bundles and
remaining final principal payments as zero coupon bonds
Clip
Take coupons from straight bonds
Stripping a bond
When fixed-income arbitrageurs create zero-coupon bonds by
buying straight bonds and clipping the coupons, bundling them,
and selling the bundles and principal payments
Bearer bonds
Bonds owned by whoever bears them
Not registered with bond issuers
Commercial paper
Short-term debt security issued by a corporation
Usually matures in nine months or less from the date its issued
Mortgage-backed securities
Bondlike instruments which receive the mortgage payments that
borrowers make on their mortgages
Back by specified set of mortgages called a mortgage pool
Mortgage pool
Specified set of mortgages that back a security
Pass-through securities
MBS is an example since they receive mortgage payments as
they are paid
Collateralized mortgage obligations
Mortgage-backed securities that divide rights to the cash flows
from the mortgage pool into several different tranches
Each tranche has a different rights to the payments that the
mortgage borrowers make
Generally structured to look like various types of bonds
Real estate mortgage investment conduits
See CMOs
Fixed income products
All debt instruments
Toxic waste
Riskiest CMO tranches
No one wants to hold them
Sell at huge discounts
Worthless if too many defaults

 High returns if few defaults

3.3.3 Derivative Contracts
- Derivative contracts
o Instruments that derive their values from the values of underlying
instruments upon which they are based
- Underlying instruments
o Instruments on which derivative contracts are based
- Zero net supply
o Sum of all long positions minus sum of all short positions is always zero
since sellers create derivative contracts when they first sell them
- Futurity
o Values of derivatives depend on future events
- Expiration date
o Date when traders make final settlement and contract expires
- Expiry
o See Expiration date
o For Europeans
- Infinitely lived
o Contracts that do not expire
o No successful ones yet
- Physically settled contract
o Requires seller deliver underlying instrument to buyer when obligated
to do so
o Buyer pays cash for the instrument at the agreed price
- Cash-settled contract
o Required the seller to deliver cash value of the underlying instrument
to the buyer when obligated to do so
o Buyer pays agreed-upon purchase price
o In practice, buyer pays difference between value and price
- Notional size
o For physically delivered contracts
o The amount the seller must deliver
- Notional value
o For cash-settled contracts
o Formula specified value that determines final cash settlement
- Varational margin payments
o Transfer money from buyers to sellers or from sellers to buyers to
adjust the prices of their contracts to reflect current market conditions
o Ensures contract values dont change as market conditions change
o Reduce the chance that traders will default when contracts expire
3.3.3.1
Some Derivative Contract Definitions
- Forward contracts
o Contracts for the future sale of some commodity
- Standardized futures contract
o Forward contracts that an exchange clearinghouse guarantees
o Doesnt matter whether other traders are creditworthy, just
clearinghouses
- Option

o Right to do something
Option contract
o Gives holders the option to buy or sell an underlying instrument at a
fixed price
- Writer
o Trader who sold the contract
- Written upon
- Underlying instrument
- Call option
o Option to buy at a fixed strike price
- Strike price
o Price at which holder can exercise its option
- Put option
o Option to sell at a fixed strike price
- Expiration date
o Date before which an option holder can exercise the option
- American-style option
o Option holder can exercise option any time before expiration date
- European-style option
o Option holder can only exercise on the expiration date
- Derivative contracts
o Option contracts depend on underlying security values
- Futures option contract
o Option contract written on a futures contract
o Holder of call option on futures contract has the right to purchase a
futures contract at a specified price
o Trade at exchange where underlying futures contracts trade
- Swaps
o Contracts for the exchange of two future cash flows
- Cash flow
o Series of payments
- Interest rate swap
o Provides for the exchange of a future series of fixed-rate income
payments for a future series of variable floating-rate interest payments
- Currency swap
o Provides for the exchange of a future series of fixed payments in one
currency for a future series of payments in another currency
- Derivative contracts
o Values of contracts depend on values of cash flows that traders swap
- Swaptions
o Options on a swap contract
o Trader who owns a swaption call has the right to buy a swap at the
specified strike price
- Swaps yield curve
o
3.3.4 Insurance Contracts and Gambling Contracts
- Insurance contracts
o Instrument that derives its value from outcomes of future events
-

People who are concerned about the loss that they would experience if
some future event takes place
- Gambling contracts
o See Insurance contracts
o Arranged by people for entertainment
- Hedgers
o People who buy insurance contracts
3.3.5 Hybrid Contracts
- Equity warrant
- Warrants
o Options that allow the holder to purchase stock at a specified price
from the issuing corporation at some time in the future
- Convertible bonds
o Holder can exchange bond for stock under some circumstances
o Combination of straight bond plus an option to exchange the bond for
stock
3.4
Where are the Trading Markets?
3.4.1 The Magnitude of Trading
3.4.2 Stock Markets
- List
o When companies have their stocks available to be traded on
exchanges
- Listing fees
o Fees paid by corporations to be listed on an exchange when they
match exchange listing standards
- Listing standards
o Require listed companies to meet specific minimum standards for
capital value, numbers of shareholders, and financial strength
- GAAP
o Method of reporting accounts
- Control structures
o How shareholders elect the board of directors who appoint the
managers and set company policy
3.4.2.1
The US Stock Markets
- Primary listing market
o Exchange where a corporate stock issue is primarily listed
- Listed stocks
o Stocks listed at the NYSE and American stock exchange
- Over-the-counter
o Stocks listed on the NASDAQ
o Now just Nasdaq stocks
- Specialists
o Dealers who assist floor brokers arrange trades for their clients on the
floor of the exchange
- Regional exchanges
o Boston stock exchange, Chicago stock exchange, Cincinnati stock
exchange, archipelago exchange, and Philadelphia stock exchange
- Unlisted trading privileges
o

Regional exchanges trading Nasdaq stocks

Privileges granted by the SEC
market
Includes dealers and brokers who arrange trades in exchange-listed
stocks away from an exchange
o Display quotes on the Nasdaq intermarket
- Alternative trading systems
o Various electronic trading systems in which US stocks trade
o Sponsored by registered broker-dealers
- Electronic communications networks
o Best known alternative trading systems
o Electronic exchanges consist most of alternative trading strategies
- Fourth market
o Trading in exchange-listed stocks within these systems
- World federation of exchanges
o Classifies markets by how they count their volumes
o Classifies NYSE as a TSV and Nasdaq as an REV
- Trading system view
o Markets count only transactions that pass through their trading
systems or that occur on their trading floors
o NYSE
- Regulated environment view
o Count all transactions that are subject to their regulatory supervision
o Nasdaq
3.4.2.2
International Stock Markets
3.4.3 Equity Options Markets
3.4.3.1
US Markets
- Side-by-side trading
- Over-the-counter
o IBs trading specialized option contracts with their clients
- Synthetic derivatives business
o Include structural products primarily swaps that IBs create for clients
o IBs trading specialized option contracts over-the-counter
- Structured products
o Usually swaps when synthetic derivatives are included
- FLEX
o Flexible exchange
o Used to capture institutional business in specialized options
- Options
- Request for quote
o Special request procedure where institutional traders specify option
type, strike price, maturity date, and exercise style
3.4.3.2
International Equity Derivatives Markets
3.4.4 Futures Markets
- Delivery months
o Usually at least 4 for commodities
- Front contracts
o Contract that will expire next
- Front month contract
o
o
Third
o

o See front contract

Back contracts
o Contracts that dont expire next
- First harvest contract
o First contract on which traders can deliver the currently growing crop
3.4.4.1
US Futures Markets
- Boards of trade
o Exchanges that trade standardized futures contracts in the US
3.4.4.2
International Futures Markets
- Futures industry
3.4.5 Corporate and Municipal Bond Markets
- Over-the-counter
o How most corporate and municipal bonds trade
3.4.6 Treasury Markets
- Interdealer brokers
o
3.4.7 Swaps and Spot Currency Markets
3.5
Market Regulation
3.5.1 Regulators
3.5.1.1
Governmental Regulatory Agencies
3.5.1.2
Self-regulatory Organizations
3.5.1.3
Other Private Regulators
3.5.2 International Regulatory Organizations
3.6
Summary
3.7
Some Points to Remember
3.8
Questions for Thought
4 Orders and Order Properties
4.1
What are Orders, and Why do People use them?
4.2
Some Important Terms
4.3
Market Orders
4.3.1 Market Orders Pay the Spread
4.3.2 Price Improvement
4.3.3 Market Impact
4.3.4 Execution Price Uncertainty
4.4
Limit Orders
4.4.1 Limit Price Placement
4.4.2 Standing Limit Orders are Trading Options that Offer Liquidity
4.4.3 The Expected Compensation for Offering Liquidity
4.4.4 The Risks of Using Standing Limit Orders
4.4.5 Limit Orders Represent Absent Traders
4.5
Stop Orders
4.5.1 Stop Orders and Limit Orders
4.5.2 Stop Orders and Liquidity
4.6
Market-If-Touched Orders
4.7
Tick Sensitive Orders
4.7.1 Tick Sensitive Order Properties
4.8
Market-Not-Held Orders
4.9
Validity and Expiration Instructions
4.10 Quality Instructions
4.11 Other Order Instructions
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4.12 Summary
4.13 Some Points to Remember
4.14 Questions for Thought