A financial market’s building blocks

A financial environment is organized around four main themes: (i) financial markets, (ii) financial institutions, (iii) financial transactions, and (iv) agents. While prices play a role in the interaction of each of these elements with each other, it is in the markets where the prices are established and from where the effects of price variations spread to the financial system and the economy as a whole.

So the following discussion will be centred on a markets’ perspective. For a market to exist and properly function, five elements are necessary: market microstructure, a price discovery mechanism, means of providing liquidity, trading infrastructure and rules, and a return realisation procedure. On top of this infrastructure, agents are necessary to run the market. The organization is depicted in the following figure:¹²¹

121 Price discovery mechanisms, liquidity and trading accomplishment are often embedded or considered a part of market microstructure, but because their relevance, here they are considered separately. ‘Agents’ is an umbrella term which includes all market participants, including financial institutions, but because institutions are also policy makers and enforcers, it’s a good idea to treat them independently.

Source: own work.

34 Market microstructure

Market microstructure is perceived in the literature as a “black-box”. It has been described as <<the study of the process and outcomes of exchanging assets under explicit trading rules>>. A broader definition describes market microstructure as <<the study of the intermediation and the institutions of exchange>>. The best definition in my opinion is that market microstructure studies the process by which investors' latent demands are translated into transactions and ultimately into prices and volumes. A central idea in the theory of market microstructure is that asset prices need not equal full-information expectations of value because of a variety of frictions.¹²²

Liquidity

Liquidity describes the degree of easiness to which an asset or security can be transformed into cash, i.e. bought or sold in the market without affecting the asset's price¹²³. Measuring liquidity is actually a relevant aspect of efficient market trading, since being a trader able to compute the expected wait time for saving the expected cost of immediate executions enhances devise a trading strategy by grouping trades, for example. In order to accomplish the aim of producing a quantitative measure of market liquidity, two questions need to be answered. Given a current market state:

 What is the expected cost of immediacy paid by traders who place market orders (i.e. liquidity takers)?

 In order to save this expected cost, what is the expected wait time for traders who place limit orders (i.e. liquidity providers)?¹²⁴

Liquidity is so relevant that sometimes the terms “liquidity” and “market” are used interchangeably.

Price discovery mechanism

Financial markets have two important functions for asset pricing: liquidity and price discovery for incorporating information in prices. One of the most critical questions in market dynamics concerns the process by which prices come to impound new information. Models of how prices are determined in securities markets are needed¹²⁵.Loosely speaking, price discovery refers to the act of determining the proper price of an asset (security, commodity, or good or service)¹²⁶. The literature on price discovery is very limited, however, a number of important research questions have been identified:

122 Asmar, Muath. “Market Microstructure: The Components of Black-Box”. International Journal of Economics and Finance, Vol. 3, No. 1. 2011.

Asmar M. provides an excellent pictorial description of the market microstructure black-box (p. 159):

123 ‘Liquidity’. Investopedia. Available at: http://www.investopedia.com/terms/l/liquidity.asp . 124 Adlar Jeewook, Kim. “ An Order Flow Model and a Liquidity Measure of Financial Markets”. Doctor of Philosophy, Massachusetts Institute of Technology. September, 2008.

125 Madhavan, Ananth. “Market microstructure: A survey”. Journal of Financial Markets, 3(3). 2000.

126 ‘Price Discovery’, Investing Answers. Available at: http://www.investinganswers.com/financial-dictionary/economics/price-discovery-3069 .

35

 Does the proliferation of alternative trading venues and the resulting market fragmentation adversely affect the price discovery process?

 How do the dynamics of price discovery of an asset depend on market characteristics, such as transaction costs and liquidity?

 What institutional structures and trading protocols facilitate the information aggregation and price discovery process?

 How structure affects return dynamics, in particular, the speed of price discovery?.¹²⁷

Price formation models can be roughly classified into centralised and decentralised. Centralised models, a.k.a.agent-based price models, the influence of the price-determination factor flow inward

―from the surrounding neighbors to the center site―. In the case of descentralised models, the influence spreads outward from the center to the neighbors¹²⁸. Price formation/discovery also include both static (such as the determinants of trading costs) and dynamic issues (such the process by which prices come to impound information over time). The informativeness of the order flow also influences the price discovery process. The extent to which the market provides independent price discovery or uses prices determined in another market as the basis for transactions can be seen a measure of how mature a market is¹²⁹. One final consideration is the role of new technological knowledge in the price discovery process¹³⁰.

Trading infrastructure

Trading materializes the essence of financial markets. All the analysis, the weighted expectations, and the algorithmic constructions find its realization in trading. Trading has evolved over time, and at the present time the star of the trading activity comes in the form of the well-known high-frequency trading (HFT). The topic in immense, so I will just give a very basic explanation. HFT refers to the automated or semi-automated trading performed by electronic systems. In practice, it relies on a state space model to decompose price movements into permanent and temporary components and to relate changes in both to high frequency trades. The permanent component is normally interpreted as information and the transitory component as pricing errors (also referred to as transitory volatility or noise). The state space model incorporates the interrelated concepts of price discovery (how information is impounded into prices) and price efficiency (the informativeness of prices). The logic is that high frequency trades (buy or sell) should go in the direction of permanent price changes and in the opposite direction of transitory pricing errors. This is done through their liquidity demanding (marketable) orders and holds on average and on the most volatile days. The informational advantage of high frequency trades’ liquidity demanding orders is sufficient to overcome the bid-ask spread and trading fees as to generally generate positive trading revenues.¹³¹

Return realization procedure¹³². Agents

The very meaning of the word agent should be made clear. For our purposes, an agent is an element in a process’s dynamics whose action or intervention produces a particular effect in that process.

Two important characteristics of financial agents are: the agent’s profile and the type of decisions they are able to take. In the financial realm, the profile of an agent includes all relevant behavioural traits that result in her actions in the market, including characteristics like preferences, elasticities,

127 Yan, Bingcheng and Zivot, Eric. “The Dynamics of Price Discovery”. 2007.

128 Sznajd–Weron, K. and Weron R. “A simple model of price formation”. International Journal of Modern Physics C, Volume 13, Issue 1. 2002.

129 Madhavan, A. (2000), op. cit.

130 Witt, Ulrich. “Competition as an Ambiguous Discovery Procedure: A Reappraisal of Hayek’s Epistemic Market Liberalism”. Papers on Economics and Evolution # 1106. Evolutionary Economics Group, MPI Jena. 2011.

131 Brogaard, Jonathan; Hendershott, Terrence and Riordan, Ryan. “High Frequency Trading and Price Discovery”. European Central Bank Working Paper Series No. 1602. 2011.

132 Hellwig, Martin F. “Risk aversion and incentive compatibility with ex post information asymmetry”.

In Differential Information Economies, Glycopantis D. and Yannelis N. (Editors). Springer, 2005.

36 sentiment sensitivity, and risk-aversion, among others. There are three kinds of financial decisions, those oriented to make a profit in the market (investment/ trading decisions), those oriented to support business activity economically (financing and capital structure decisions) and those related to the financial activities necessary for running an enterprise (holding decisions). All financial decisions involve risk management.

An agency problem, arises when one party enter a conflict of interest when she is expected to act in another’s party best interest but has interests on her own. Traditionally, agency problem’s scope focus in corporate finance (managers vs. stockholders). In financial markets however, a peculiar form of agency problem arises. In modern economies, a significant share of financial wealth is delegated to professional portfolio managers rather than managed directly by the owners, creating an agency relationship¹³³. Managers are paid fees, and the structure of fee payments can have an impact both in the manager’s behaviour and in the price of the portfolio. With asymmetric performance fees¹³⁴, <<the composition of the portfolios selected by fund managers depends critically on the funds’ excess return>>. Interestingly, it can also <<stabilize prices by decreasing the equilibrium stock volatilities of both benchmark and non-benchmark stocks, although portfolio turnovers are higher>>.