Making Market Microstructure Matter

Author(s): Maureen O'Hara

Source: Financial Management , Summer, 1999, Vol. 28, No. 2 (Summer, 1999), pp. 83-90
Published by: Wiley on behalf of the Financial Management Association International

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 Contemporary Issues

Making Market Microstructure Matter

Maureen O'Hara

Market microstructure research has provided important insights into

Maureen O'Hara isof
Purcell Professor the RobertatW.
Finance the operation and behavior of securities markets and into the intra-day
Cornell University. behavior of asset prices. What has not yet been established is how
market microstructure affects economic behavior more generally. This
article focuses on the quest for the link between microstructure and
economic meaning. It looks at several areas where microstructure should
matter, and it suggests ways for looking for such a linkage. The article
attempts to define what we know and don't know regarding
microstructure effects, as well as suggesting a research agenda of what
we ought to know.

SWhat does market microstructure tell us ofmatters

any quite a lot. But, from another perspective, we
value? How does the microstructure of markets matter?
could view this situation as merely a transfer problem:
These may seem like odd questions to ask after morethe dealers took from the traders, and the lawyers took
than a decade of microstructure research, but I think
from the dealers, but on balance the pie was still the
they point to a crucial research issue confronting
same. Taking a somewhat less cynical view, we could
finance researchers. We know that microstructureargue that the subsequent changes in the NASDAQ
should matter in the sense that it affects economicmarket may have affected the size of the pie, but how it
decisions or variables, but how exactly it does matter
actually affected overall welfare remains unclear. I think
such welfare issues are extremely important, and I
is not clear. We are, perhaps, in the perplexing situation
that while markets appear to work in practice, we willare
return to them later. First, I want to focus our
not sure they work in theory. attention on other, more basic issues. Does market
microstructure
The focus of this article is on the quest for this link actually affect economic behavior?
between market microstructure and economic meaning. To address this issue, I will outline three areas where
This focus may seem puzzling coming in the wake market
of microstructure should matter, but it is not clear
Bill Christie and Paul Schultz's renowned research on how it does. My focus is on determining not only what
the NASDAQ. Certainly, for the NASDAQ market
we know and do not know, but also in defining a
research agenda of what we ought to know.
makers who had to settle up (and for the myriad lawyers
and finance colleagues who happily billed by the hour
while this was all sorted out) microstructure research
I. Asset Pricing

This article was presented as the Keynote Address at the If markets matter, then surely one place it should be
Financial Management Association International Annual evident is in asset pricing. We know that a major focus
Meeting in Chicago, IL, October 1998.
of market microstructure research is on the process by
I would like to thank the Editors and David Easley, Robert
Jennings, Katrina Ellis, Gideon Saar, and Soeren Hvidkjaer for which information is incorporated into prices. Market
their help with this project. The author can be reached at microstructure models provide structural models of
MO19@cornell.edu. how prices become efficient, as well as models of

Financial Management, Vol. 28, No. 2, Summer 1999, pages 83 - 90

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 84 FINANCIAL MANAGEMENT / SUMMER 1999

volatility, both issues clearly

that the link in the of importance
literature between asymmetric f
asset pricing. But of information
perhaps and assetmore
pricing is notimportanc
yet apparent.
microstructure models can provide
How can explicit
we put this market estimates
microstructure construct
of the extent of private information. We know
into an asset-pricing framework? that
Put differently, howthe
can we show
is a link between this private that microstructure factors
information andsuch as
spreads
information
but does it go further than that? affect asset prices? One difficulty
In particular, if a stoc is
has a higher probability that
of asset-pricing
private models
information,
in general do not shou
work
that have an effect on its required
particularly return?
well! Consider what the data tell us from
This issue has been addressed in various
the last approximately ways
20 years. (See Table 1.) It in
the literature. Perhaps the most straightforwar
does not appear that even market risk was priced
approach is that of Amihud
over thisand
period.Mendelson (1986) wh
considered a variant of this
While Iproblem by
have no interest in arguing
entering that
that perennially
liquidity should be priced.
favorite Their
debate over argument was th
the demise of the capital-asset-
only investors with long horizons
pricing model, I thinkwould hold
all would agree illiquid
that the CAPM
did not work
stocks, which in their model as hoped for over
is proxied by this
the period. This
bid/ask
spread. In equilibrium, this clientele
difficulty effect
set the stage for would
the Fama-French resu
(1993) three-
in higher required returns
factorfor
model, illiquid stocks.
which works better, Thus
but again th
I think we
question became, is liquidity priced?
could agree that it is not yet the definitive asset-pricing
Amihud and Mendelson model. present
Moreover, evidence
a troubling aspectthat it is
is that there is,
no
but the overall research on
economic this for
justification question
this structure, ahas bee
point made
mixed. Calculating a crude scoreclarity
with admirable card, we Sarkissian,
by Ferson, find and Amihu
Simin
and Mendelson (1986) and (1999) Datar,
in their paper Naik,
developingand Radclif
an alphabet-pricing
(DNR) (1998) arguing that model. it
All ofisthispriced, and
leads us to ponder anew Chalme
the
and Kadlec (1998), Chen and Kan (1995), and economics of asset prices.
Eleswarapu and Reinganum (1993) suggesting that Davidit Easley and I have been working on the
is not. Certainly, one might agree with DNR when they
general question of empirically implementing market
microstructure models, and this research lends itself
admit "whether liquidity affects asset returns or not
remains unresolved thus far." to the issue at hand. Consider what we know from a
One difficulty in resolving this issue lies in exactly microstructure model. Microstructure models can be
viewed as learning models in which market makers
what is being sought. Is this higher return, if it exists,
due to compensation for some exogenous illiquidity watch some particular market data and draw inferences
that manifests itself in large spreads, or is it a return
about the underlying true value of an asset. Crucial to
for bearing the risk of higher private information thatthis inference problem is the market maker's estimate
is also reflected in high spreads? These issues areof the probability of trading based on private
obviously related, but they are not the same. The information about the stock. Using trades as an input,
illiquidity arising from some exogenous factor (such
we can use our structural model to work backwards to
provide specific estimates of the risks of information-
as limited competition between dealers, for example) is
akin to a tax, and its effects might be reasonably
based trading in a stock.
anticipated. The effects of private information are As an example, consider a simple sequential trade
more complex, however, because of their link to the tree diagram as in Figure 1. Its parameters reflect the
dynamic efficiency of asset prices. Do traders need
rates of uninformed trading (E), informed trading (p),
compensation to hold a stock that is exposed to
and information arrival (ca), and the propensity towards
greater asymmetric information? bad versus good news (6). This structure can be
estimated via maximum likelihood. The model tells us
Perhaps the research closest to examining this issue
is that of Brennan and Subrahmanyam (1996), who
how to use the resulting parameters to determine the
probability of information-based trading. For example,
investigate empirically the role of a Kyle-, in asset
pricing. The results here are difficult to interpret, in
the daily likelihood for the trading process in Figure 1
is given by
part due to data problems, but they are intriguing. They
do find support for the notion that X somehow matters
in affecting asset returns. But what motivates this = -- __- + ot~e- e-(,+e),
result (and how to interpret it) is not clear. Could this L((B,S) 10) = (1-) e (B!
e + et)s
S!e B!
(e~e)B
relationship be due to inventory considerations or to
liquidity problems more than to information effects? I
[(L
S! +")]s
+ B!
+a(1
S! [(.+~)
-)e-()
do not think the structure tested in their work allows
these issues to be disentangled, leaving us to agree where L (.) is t

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O'HARA / MAKING MARKET MICROSTRUCTURE MATTER 85

Table 1. The Relation Between Excess Returns and Beta

The table contains average monthly excess returns above the Treasury rate sorted by size and beta quintil
portfolio rebalancing in the period 1980 - 1997. The sample consists of all common stocks listed on the

Beta Quintile

Size Quintile Low 2 3 4 High

Small 1.06 0.79 0.62 0.38 0.63
2 0.60 0.72 0.69 0.46 0.34
3 0.70 0.81 0.76 0.67 0.39
4 0.65 0.88 0.80 0.79 0.50

Large 0.83 0.97 0.80 0.74 0.55

Figure 1. Tree Diagram of th

c is the probability of an information

E is the rate of uninformed buy and

Buy Arr

Signal Low

Sell Arrival Rate

C+jJ.

Information
Eve nt Occurs

Buy Arrival Rate

5+11
Signal High
(1-8)

ZSell Arrival Rate

Information Event
Does Not Occur Buy Arrival Rate
(1-cx)

Once
Day
per S ell Arrival Rate

vector aversion parameters because these factors do not enter

(a,E,6,j1),
buy and sell
into the model. trad
Instead, these estimates represent a
days is then
pure foun
measure of the risk of private information in a
particular stock. We have
functions. Thisused this measure to show p
how spreads differ between frequently
probability of and in
which infrequently traded
for stocks (Easley, Kiefer, O'Hara,
the sim and
Paperman, 1996) and to investigate how informed
PI= at (2) trading differs between market venues (Easley, Kiefer,
ut + 2E and O'Hara, 1997). If we try to use this measure in an
asset-pricing model, what will we find?
More complex models can also be estimated, This question has been the focus of work we have
allowing for greater complexity in the trading andbeen doing with Soeren Hvidkjaer. Using an approach
information processes. similar to that of Brennan and Subrahmanyam, we have
This estimated measure of information-based tradingestimated the probability of information-based trading
is not related to inventory or to any presumed riskfor every stock on the NYSE for the period 1984-1991.

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 86 FINANCIAL MANAGEMENT / SUMMER 1999

This exist, but has yet to be firmly

research is a substantial established.
project becau
using every trade in every
Again, stock
part of the difficulty in looking forover
this linkage rol
is that we do not really
time horizons to estimate thehave many well-functioning
underlying
corporate finance
Before turning to any theories. When I went to graduate
asset-pricing issues
first need to school, we
think were still firmly
about thein the grasp of the
propert
"irrelevance" schoolis
estimates. Their stability of thought,
of which even at that
particular
time was not viewed with any enthusiasm
Figure 2 shows a distribution of the by actualpro
information-based trading
managers (who, I fear, found (PINF)
it largely irrelevant).across
What
has transformed
stocks listed on the New York corporate financeStockis asymmetricExch
sample 1984information,
period
- 1991. the sameTheeconomic estimates
phenomenon so
economically "reasonable" in that
important in market microstructure. the
Now dividends do t
has an approximately
matter, capital20% probability
structure is important, and we are back
trading. We have to also performed
linking corporate stab
finance decisions with economic
determine whetherproduct
the marketestimated
behavior. It seems only natural that
parame
over time. The results displayed
the information we analyze in the formation of in
security Fig
prices should have
remarkable consistency. We some effect
find on the corporations
the year
PINF that issue
is less than 0.05 for the securities
over in the first
70% place! of the
Suppose we now put Certainly,these estimates
there is some empirical evidence that where in
pricing model. What securities
do list we
has economic importance. Christie
find? It is and clea
2 that the relation Huang
is (1994)
not examine stocks that move
quite from a dealer
what we w
we should expect to market
see (the NASDAQ) to an auction market (the
a positive, NYSE
monot
or the AMEX).
between excess return and They find
PINF.an average trading
There cost do
reduction of approximately
be a difference in returns betweenfive cents per share,
verya
reduction they attribute to quote
high PINF stocks, particularly improvements
for smalland st
in the right the routing of trades
direction. to the NYSE. Even stronger
However, it is
monotonic, in evidence is provided
general. How by an then
intriguing recent
do studywe
by e
Amihud,point
performance? At this Mendelson, andweLauterbach
are (1997).
notThey sur
continuing to work show
on that this
changing theproblem
trading mechanism on with
the Tel a
incorporating our Aviv Stock Exchange from a into
estimates call to a continuous
a form
four-) factor structure increased stock prices by an average of 5.5%.
model.
I would Since the
argue that individual stocks did not change, thisthe
establishing lin finding
market microstructure
is compelling evidence variables and a
that the market microstructure
can influence
models is among the most asset prices in secondary markets. areas
promising But
how could we tell if
I have outlined one approach that I am market microstructure also affects
a company's cost of capital?
but there are undoubtedly others. Cert
that incorporate One place to look
variance is in the placement of new
properties are a
securities. From
link to pursue. Indeed, the a company's
new perspective, cost of
generatio
GARCH models, the capital
ACDis directly tied to the primary trading
models being of its wo
Rob Engle and hissecurities.
students So if market microstructure
(see, affectsfor
trading, ex
and Russell, 1997), then
lookit directly affects the company.
very much There has like
been th
models developed in somethe
work donemicrostructure
on the microstructure of IPOs by l
it seems sensible to me that there should be a link researchers, including Kathleen Hanley, Paul Schultz,
between the microstructure of asset markets and asset Jay Ritter, Paul Sequin, Charles Lee, and Roni Michaely,
pricing; if so, it is up to researchers to find it. but in general we have been limited in this research by
the lack of data.
In new research with Roni Michaely and Katrina Ellis
II. Corporate Finance (see Ellis, Michaely, and O'Hara, 1999), I have been
investigating this link between securities trading and
Should companies care where their stock is listed?
Does the particular microstructure of a market lower
the underwriting of IPOs. Our project involves
a company's cost of capital or allocate capital approximately 300 IPOs first quoted on the NASDAQ
"better" for the economy as a whole? Does market market in 1996-1997. We are very fortunate to have a
microstructure explain any corporate puzzles, suchcomplete set of microstructure data (prices, quotes, trades,
as the underpricing of initial public offerings? These and identities) for each IPO. The NASDAQ Economic
questions address the link between microstructure andResearch group provided these data to us, and we are
corporate finance, another area where it must surely grateful to them for fostering research in this area.

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 O'HARA I MAKING MARKET MICROSTRUCTURE MATTER 87

Figure 2. Distribution of Probability of Information-Based T

This figure gives the probability distribution for an estimated probabilit
for all common stocks listed on the NYSE, and are calculated for rolling

Distribution of PINF, pooled data

1200

1000

800

o 600
E
z

400

200

00( 0 06 0 000 00( o ' * PIN

0 ....0 0, 0. 0, 0. . . 0. PINF

Table 2. The Relation Between Excess Return and the Probability of Information-Based Trading
The table contains average monthly excess returns above the Treasury rate sorted by size and probability of information-
based trading by quintile with annual portfolio rebalancing in the period 1984 - 1991.

PINF Quintile

Size Quintile Small 2 3 4 Large

Small 0.05 0.09 -0.04 -0.03 0.62
2 0.17 0.26 0.05 0.31 0.29
3 0.51 0.28 0.53 0.65 0.60
4 0.66 0.72 0.62 0.80 0.65
Large 0.78 0.81 0.58 0.71 0.80

Our focus in this research is on the role of the take surprisingly large positions in faltering issues. In
underwriter, and in particular, on how the trading
the absence of this price support, it is likely that the
function interacts with the underwriting function in
price of the issue would fall even faster than it does,
the issuance of new securities. Since for NASDAQ
raising the cost to the company of a stock issue.
IPOs the managing underwriter becomes one of the
Second, we find some evidence that the underwriter
market makers, we have an intriguing opportunity to benefits from the extent of the underpricing. We do
measure the impact of market activities on this process.
not find that he benefits from overpricing. We find
Two preliminary findings appear quite relevant to
this result quite heartening because it seems
this paper. First, as shown in Table 3, we find enormous
tantalizingly close to being the link between corporate
differences in the inventory position the market makerfinance and market microstructure we are seeking.
takes in the after-market trading of the issue, which And yet ... a problem remains. It is not clear how
depends upon the issue's performance. Market makerseconomically important or robust this profit effect is.

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 88 FINANCIAL MANAGEMENT / SUMMER 1999

Table 3. Lead Underwriter Invento

This table gives the lead underwriter's invent
All sample firms are initial public offerings
are stratified by return measured over the fi

First Day Return

Whole Sample <0% 0% <10% >10%
# Obs 312 24 56 105 127

Day 1 3.68 12.19 10.58 2.91 -0.33

1.56 10.27 8.90 1.35 0.06

F = 26.74*** KW = 99.25***

Day 5 6.05 15.06 15.23 5.23 0.97

3.70 13.98 14.38 3.60 1.00

F = 32.55*** KW = 101.38***

Day 10 7.0 16.76 16.91 6.47 1.23

4.22 14.81 15.75 4.53 1.09

F = 37.46*** KW = 109.58***

Day 20 7.63 15.21 17.04 7.25 2.36

4.57 15.20 17.25 5.60 2.23

F = 27.52*** KW = 78.52***

Day 60 7.40 12.07 16.01 7.82 2.37

4.65 12.22 16.30 6.13 1.71

F = 19.60*** KW = 63.45***

***Significant at the 0.01 level.

Our results also suggest that the vast majorityby

ofsuch
the models, particularly the rather stoic behavior
underwriter's compensation comes from fees, with traders who are presumed to trade no matter
of liquidity
trading profits representing only a small fraction what. of
Yet, intuitively, we know that these welfare issues
his total profits measured as of the first month must be oflarge, and since Christie and Schultz we know,
trading. So we are not yet there, and clearly more empirically,
work that they are.
needs to be done. Does market microstructure affect Many questions of interest arise here, and they are
typically questions of market design. Should the
the issue price? It would be nice to investigate this
issue in the context of other markets with different
regulators allow order preferencing in markets, a
microstructures, but this research requires data that
practice that undercuts the principle of time priority in
markets? Should a market be transparent or not? Is the
are not yet available. Nonetheless, this question seems
a promising direction in which to look for the best linkmarket the one that treats every order the same,
between market microstructure and economic behavior.
or should markets be allowed to develop in order to
meet specialized needs? These questions are of
III. Market Microstructure and Welfare huge importance, but what is the best way to address
them? In particular, how do we show that issues of
Effects
market design matter?
One approach is to look at experimental economics.
Having looked a bit farther afield, let's return to the
Experiments allow you to control specific features of
linkage between market microstructure and welfare
market design and then calculate the impact on market
effects noted earlier. One group you do not need to
behavior and trader welfare. Robert Bloomfield and I
convince that the microstructure of markets has real
effects is market participants. They know it matters if have been looking at experiments to determine the
effects of transparency on market performance
for no other reason than it distributes the welfare gains
of trading across different players. But a criticism of(Bloomfield and O'Hara, 1999a). We have been
microstructure models, and a fair one at that, is thataddressing the basic question of what happens when
they can give little or no guidance on these welfare you change market information.
effects. This lack of guidance is largely the result of There are two reasons why this issue is important.
the exogeneity of traders' motivations that is requiredFirst, what information is allowed in a market changes

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O'HARA / MAKING MARKET MICROSTRUCTURE MATTER 89

the distribution of gains. Who

among exchangeswe want
is important, a market
but there is perhaps a to
benefit is a question that more
hasfundamental
not reallyquestion that should be
been asked. Does
addressed,
and yet it fundamentallyinternational
alters listing
how help
weor hurt local economies?
might design
markets. Second, and what is perhaps
While individual companies may becoming
be better off when the
predominant issue, changing market
they list elsewhere, structures
does their attrition to other venues
changes the competitiveness of markets.
impair the functioning If there
of the domestic market? This is is
one issue that is front and center
essentially today,
a welfare it
question, and is where
it highlights another will
area where I think research is needed to establish the
trading occur in the future.
link between markets
Let me focus on this competitive and macroeconomics.
issue for a moment.
Rob and I have developedI have
annot experiment looking
worked in this area, due at
sadly to the fact
whether transparent markets
that I havecan
no ideasurvive when
how to do so. But I suspectfaced
that it
with competition fromis here that researchers will find that the structure
non-transparent venues of
(Bloomfield and O'Hara, 1999b).
markets is ofIn our set-up,
real economic traders
importance, particularly in
can choose to send orders tocountries.
developing a transparent market
Domowitz, Glenn, and Madhavan
(1997, 1998),
where all market participants view Karolyi (1996), Hargis
trades, orandto Ramanial
a non-
transparent market, where (1998),
only Levine
the (1999), and Smith
dealer and Sofianos
sees (1997)
the trade.
all address this issue.artificial,
This set-up may seem somewhat But so much more needs
but to it is
be done. If,for
reminiscent of the competition as some early research
large ordershas shown,
between
Paris and London in which orders in London have international listing increases the size of the pie for
delayed reporting while those in Paris do not. Thedomestic market and the international market,
both the
paper looks first at how transparent and non- then the microstructure of any one market may not be
transparent market makers fare in this competitiveimportant. But if international competition becomes
environment, and at how traders do in the various more of a fixed-sum game, then how orders flow across
regimes. We then change the game by allowing dealersmarket borders has implications for capital formation
to choose whether to be transparent or not, which allowsand economic welfare.
us to consider the question of what type of market will Addressing this link, however, requires a theory to
endogenously arise in a world of competition. explain how stock market efficiency affects economic
We find that traders are sophisticated in their tradingefficiency. And so, perhaps not unexpectedly for a
choices, with informed traders occasionally entering theorist, I bring us back to the argument that what is
trades in the transparent market that are the oppositereally needed is more theoretical work. Here I think a
of those they are doing in the non-transparent setting. very insightful paper by Dow and Gorton (1997)
But what is even more intriguing is what happens to provides an excellent starting point. They argue that
the market makers. Since a non-transparent dealer stock prices can affect economic efficiency because
learns information from orders that is not shared with stock prices play a role in a firm's investment decisions.
the market, it is more valuable to him to capture the The intuition they offer is that the market may know
early (informative) order flow than it is to the more about the prospects of a firm's future investment
transparent dealer. This aggressiveness allows the non-opportunities than the managers of the firm because
transparent dealer to post the inside spread more the informed investors have been busy ferreting out
frequently, and equally important, to avoid being on information. Thus, the managers can learn from the
the "wrong" side of the market. While the transparent informationally efficient stock price, and by tying the
dealers in our markets compete to earn zero profit, the managers' compensation to the stock price, this link
non-transparent dealers make substantial profits. provides the right incentives to promote the efficiency
When we then allow dealers to endogenously of both the firm and the market.
choose their type, the majority opt to be non- Whether this relationship is the right linkage is not
transparent. Interestingly, they all do not choose this clear to me. But I do like the intuition that the market
outcome because being the only transparent dealer in does more than find out the information that others
a non-transparent world turns out to be valuable. already know. It certainly seems economically
Nonetheless, our work suggests that market structures reasonable that markets should be capable of doing
can have both real effects on participants and more than that.
fundamental effects on market competitiveness.
Apart from being interesting from an academic IV. Conclusions
perspective, why is this research important? One reason
is that it relates to a very real debate occurring now over Does market microstructure matter? I have tried to
the competition for listings between domestic and argue in this article that it does, and to suggest ways
international exchanges. The issue of competitiveness in which it affects economic variables. But the actual

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 90 FINANCIAL MANAGEMENT / SUMMER 1999

results and
linkages, and their economic because of
importance, r
defined. research
I view this area can provide
of research i
as havin
promise, both because (and unresolved)
of the likelihoodissue
of f

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