Financial Markets Microstructure: Understanding Market Prices, Liquidity, and Institutions

The video opens with a warm welcome to the Financial Markets Microstructure course, a master's level class taught at the University of Copenhagen in spring 2020. The instructor, Igor Starkov, explains how the COVID-19 pandemic shifted most lectures online, with 10 out of 16 lectures and 3 out of 5 exercise classes livestreamed and uploaded to YouTube. To complement these, he re-recorded some lectures to provide a more complete course experience, though these new recordings are one-take and unedited to avoid creating unrealistic expectations about quality.

"I would like to warn you that these recordings will be one pass with no editing whatsoever... not create a sudden quality shock." 1:23

All course materials, including slides, problem sets, and reading lists, are available on Starkov’s personal website. The course is primarily based on the textbook by Terry Foucault, Marco Pagano, and Ilse Höy (2013), which covers two-thirds of the content. The latter part of the course shifts focus to research articles, presented in a more digestible and creative manner.

Key points:

• Course affected by COVID-19, mostly online.
• Materials and readings available on instructor’s website.
• Textbook by Foucault, Pagano, and Höy is the main reference.
• Second half of the course focuses on research articles beyond the textbook.

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The instructor steps back to define what a market is: broadly, a set of institutions where property rights are exchanged between economic agents. This can be a physical place, a digital platform, or even an abstract concept (e.g., illicit markets like drugs or weapons).

"A market broadly speaking is a set institution in which property rights are exchanged between different economic agents." 5:23

Markets are studied because they enable efficient allocation of resources—ideally, items move from those who value them less to those who value them more, increasing social welfare.

Key points:

• Markets facilitate exchange of property rights.
• Efficiency means assets end up with those who value them most.
• Studying markets helps understand how to ensure efficient allocation.

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Financial markets trade financial assets—stocks, bonds, derivatives—essentially buying money with money, aiming to yield more money in the future. Two main reasons for trading financial assets are:

1. Reallocating wealth over time (e.g., investing in riskless assets).
2. Reallocating wealth across different future contingencies (e.g., hedging against industry-specific risks).

"Financial assets allow you to move wealth across time and contingencies." 11:34

A key feature of financial markets is asymmetric information: different agents have different knowledge about future states of the world, which complicates market efficiency.

Key points:

• Financial assets represent claims to future money.
• They enable wealth transfer over time and across uncertain future states.
• Asymmetric information is a defining challenge in financial markets.

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Financial markets split into:

• Primary markets: where new securities are issued (e.g., IPOs, treasury auctions). Money flows directly to firms or governments.
• Secondary markets: where existing securities are traded among investors. The course focuses mainly on secondary markets.

Examples of secondary markets include stock markets, bond markets, derivatives markets, foreign exchange, and commodity futures markets.

"In secondary markets trade happens between different owners and potential owners or holders of the assets." 19:26

Key points:

• Primary markets allocate savings to investment.
• Secondary markets facilitate liquidity and reallocation of existing assets.
• Secondary markets are the main focus of this course.

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The course centers on understanding how market prices emerge and whether they reflect fundamental values. Classical economics posits prices are set by supply and demand equilibrium, but this course digs deeper into the microstructure—who sets prices, how trader behavior and market environment influence prices.

"How exactly does the market arrive to this price?" 24:10

The instructor highlights the importance of bid and ask prices, which create a bid-ask spread—a friction that can impede market efficiency.

"The difference between the bid and the ask price is called the bid ask spread." 36:49

Key points:

• Market prices are not a single number but a bid and ask.
• The bid-ask spread represents a cost/friction in trading.
• Understanding price formation requires analyzing trader interactions and information asymmetry.

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Liquidity is introduced as the market’s ability to facilitate quick sales without large price concessions. It is a core measure of market quality.

"Market liquidity is the market's ability to facilitate an asset being sold quickly without having to reduce its price very much." 51:46

Market depth is a related concept measuring how large an order must be to move prices by a certain amount. Depth can be seen as the sensitivity of liquidity to order size.

Key points:

• Liquidity measures ease and cost of trading.
• Depth measures how price impact grows with order size.
• Both concepts are central to understanding market efficiency and trader costs.

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Markets are broadly categorized into:

• Order-driven markets: traders submit orders to a limit order book; trades occur by matching buy and sell orders.
• Dealer markets: trades occur through intermediaries (dealers or market makers) who quote bid and ask prices and absorb order flow.

Order-driven markets can be:

• Continuous: orders are matched and trades executed continuously.
• Call auctions: orders accumulate over a fixed period and are matched simultaneously at a single clearing price.

"In order driven markets, orders are submitted into a common limit order book and matched." 57:08
"In dealer markets, all trades happen through a centralized intermediary." 57:37

Key points:

• Order-driven markets rely on direct matching of orders.
• Dealer markets use intermediaries who provide liquidity.
• Continuous vs. call auction trading affects speed and pricing.

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Two main order types:

• Limit orders: specify quantity and price limit; remain in the book until executed or canceled.
• Market orders: specify quantity and execute immediately at the best available price.

Patient traders tend to use limit orders (providing liquidity), while impatient traders use market orders (taking liquidity).

"Patient traders are usually more passive... they provide liquidity." 1:09:02
"Impatient traders are more aggressive... they take liquidity." 1:09:09

Key points:

• Limit orders add liquidity; market orders consume liquidity.
• Order choice reflects trader urgency and strategy.
• The bid-ask spread arises partly from this liquidity provision/taking dynamic.

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Examples of continuous limit order book exchanges include the New York Stock Exchange and London Stock Exchange. Call auctions are used at market openings and closings or in some parallel venues (e.g., Nasdaq).

Uniform pricing in call auctions can improve efficiency by eliminating bid-ask spreads within the batch, but slower trade execution may deter impatient traders.

"Uniform pricing gives us some very good efficiency properties." 1:13:14
"Trades happen slower than in continuous markets." 1:13:43

Key points:

• Continuous markets offer immediacy; call auctions offer uniform pricing.
• Market design choices involve trade-offs between speed and efficiency.
• Real-world exchanges often combine multiple trading mechanisms.

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Dealers act as intermediaries, quoting bid and ask prices and managing inventory risk. They earn profits to cover operational costs, inventory risk, and adverse selection from trading with better-informed counterparties.

"Dealers will likely quote a positive bid ask spread... to generate trading profits." 1:16:26

Nasdaq is a prime example of a dealer market.

Key points:

• Dealers provide liquidity when direct matching is unavailable.
• They balance profit motives with competitive pressures.
• Inventory and information risks shape dealer pricing.

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Regulators aim to:

• Protect uninformed traders from being exploited by informed traders.
• Maintain price discovery by encouraging informed trading.
• Stabilize markets to reduce extreme volatility.
• Select optimal trading structures for different asset types.

"You want to trade off protection of uninformed investors and price discovery." 1:35:58

Regulatory tools include:

• Routing requirements between fragmented markets.
• Transaction taxes or subsidies.
• Margin requirements to reduce counterparty risk.
• Rules on algorithmic and high-frequency trading.
• Managing competition among exchanges to balance liquidity and fees.

Key points:

• Regulation balances competing goals: fairness, efficiency, stability.
• Market fragmentation and competition have complex effects.
• Policy choices impact liquidity, transparency, and market quality.

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Three main groups:

• Traders/Investors: retail (individuals) vs. institutional (professionals like pension funds, mutual funds).
• Dealers/Market Makers: intermediaries providing liquidity.
• Brokers: intermediaries connecting traders to dealers or exchanges.

Traders can be:

• Informed: trading on private information.
• Uninformed: trading for liquidity or hedging reasons.

"Retail investors are often uninformed; institutional investors are often informed." 1:31:52

Key points:

• Different participants have different motivations and information.
• Brokers facilitate access to markets for retail investors.
• Understanding participant roles is key to analyzing market microstructure.

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The instructor suggests practical exercises:

• Look up bid and ask prices for popular stocks (e.g., Facebook, Microsoft).
• Identify which exchanges these prices come from.
• Read about the London Metal Exchange and the value of physical trading floors in the digital age.
• Solve textbook exercises comparing continuous and call auction markets.

"What is the value of keeping the open outcry trading floor in the age of digital trading?" 1:43:24

Key points:

• Engage with real market data to understand concepts.
• Explore institutional features like physical trading floors.
• Apply theoretical knowledge through exercises.

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This detailed breakdown captures the full scope of the lecture, preserving the instructor’s narrative style and emphasizing key concepts, definitions, and examples essential for mastering financial markets microstructure.