nep-mst New Economics Papers
on Market Microstructure
Issue of 2021‒05‒10
six papers chosen by
Thanos Verousis

  1. Order flow and price formation By Fabrizio Lillo
  2. (In)efficient repo markets By Dieler, Tobias; Mancini, Loriano; Schürhoff, Norman
  3. Intermediation and Price Volatility By Gehrig, Thomas; Ritzberger, Klaus
  4. Deep Reinforcement Trading with Predictable Returns By Alessio Brini; Daniele Tantari
  5. Strategic Fragmented Markets By Ana Babus; Cecilia Parlatore
  6. The Homogenous Properties of Automated Market Makers By Johannes Rude Jensen; Mohsen Pourpouneh; Kurt Nielsen; Omri Ross

  1. By: Fabrizio Lillo
    Abstract: I present an overview of some recent advancements on the empirical analysis and theoretical modeling of the process of price formation in financial markets as the result of the arrival of orders in a limit order book exchange. After discussing critically the possible modeling approaches and the observed stylized facts of order flow, I consider in detail market impact and transaction cost of trades executed incrementally over an extended period of time, by comparing model predictions and recent extensive empirical results. I also discuss how the simultaneous presence of many algorithmic trading executions affects the quality and cost of trading.
    Date: 2021–05
  2. By: Dieler, Tobias; Mancini, Loriano; Schürhoff, Norman
    Abstract: Repo markets trade off the efficient allocation of liquidity in the financial sector with resilience to funding shocks. The repo trading and clearing mechanisms are crucial determinants of the allocation-resilience tradeoff. The two common mechanisms, anonymous central-counterparty (CCP) and non-anonymous over-the-counter (OTC) markets, are inefficient and their welfare rankings depend on funding tightness. CCP (OTC) markets inefficiently liquidate high (low) quality assets for large (small) funding shocks. Two innovations to repo market design contribute to maximize welfare: a liquidity-contingent trading mechanism and a two-tiered guarantee fund.
    Keywords: asymmetric information; Central clearing; Collateral; Financial Stability; funding run; guarantee fund; novation; repo market
    JEL: G01 G14 G21 G28
    Date: 2021–02
  3. By: Gehrig, Thomas; Ritzberger, Klaus
    Abstract: This paper analyses the role of intermediaries in providing immediacy in fast markets. Fast markets are modelled as contests with the possibility of multiple winners where the probability of casting the best quote depends on prior technology investments. Depending on the market design, equilibrium pricing by intermediaries involves a trade-off, between monopolistic price distortion and excess volatility. Since equilibrium at the pricing stage generates an externality, investments into faster trading technologies are necessarily asymmetric in equilibrium, akin to markets with vertical product differentiation. Further, equilibrium is not necessarily effcient, since it is possible that a high-cost intermediary ends up investing excessively and thus trades more frequently than low-cost rivals.
    Keywords: High-frequency trading; intermediation; market design; Price volatility
    JEL: D43 D47 G14 L13
    Date: 2021–02
  4. By: Alessio Brini; Daniele Tantari
    Abstract: Classical portfolio optimization often requires forecasting asset returns and their corresponding variances in spite of the low signal-to-noise ratio provided in the financial markets. Deep reinforcement learning (DRL) offers a framework for optimizing sequential trader decisions through an objective which represents its reward function penalized by risk and transaction costs. We investigate the performance of model-free DRL traders in a market environment with frictions and different mean-reverting factors driving the dynamics of the returns. Since this framework admits an exact dynamic programming solution, we can assess limits and capabilities of different value-based algorithms to retrieve meaningful trading signals in a data-driven manner and to reach the benchmark performance. Moreover, extensive simulations show that this approach guarantees flexibility, outperforming the benchmark when the price dynamics is misspecified and some original assumptions on the market environment are violated with the presence of extreme events and volatility clustering.
    Date: 2021–04
  5. By: Ana Babus; Cecilia Parlatore
    Abstract: We study the determinants of asset market fragmentation in a model with strategic investors that disagree about the value of an asset. Investors' choices determine the market structure. Fragmented markets are supported in equilibrium when disagreement between investors is low. In this case, investors take the same side of the market and are willing to trade in smaller markets with a higher price impact to face less competition when trading against a dealer. The maximum degree of market fragmentation increases as investors' priors are more correlated. Dealers can benefit from fragmentation, but investors are always better off in centralized markets.
    JEL: D43 D47 G12
    Date: 2021–04
  6. By: Johannes Rude Jensen; Mohsen Pourpouneh; Kurt Nielsen; Omri Ross
    Abstract: Automated market makers (AMM) have grown to obtain significant market share within the cryptocurrency ecosystem, resulting in a proliferation of new products pursuing exotic strategies for horizontal differentiation. Yet, their theoretical properties are curiously homogeneous when a set of basic assumptions are met. In this paper, we start by presenting a universal approach to deriving a formula for liquidity provisioning for AMMs. Next, we show that the constant function market maker and token swap market maker models are theoretically equivalent when liquidity reserves are uniform. Proceeding with an examination of AMM market microstructure, we show how non-linear price effect translates into slippage for traders and impermanent losses for liquidity providers. We proceed by showing how impermanent losses are a function of both volatility and market depth and discuss the implications of these findings within the context of the literature.
    Date: 2021–03

This nep-mst issue is ©2021 by Thanos Verousis. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.