Security market microstructure: The analysis of a non-frictionless market

Abstract

The capital asset pricing model describes a frictionless world characterized by infinite liquidity. In contrast, trading in an actual marketplace is replete with costs, blockages, and other impediments. Equity market microstructure focuses on how orders are handled and turned into trades in the non-frictionless environment. For over three decades, the literature has grown while, concurrently, trading systems around the world have been reengineered. After depicting the frictionless CAPM, we consider the development of microstructure analysis, concentrating on issues germane to market architecture. We then consider the design of one facility, Deutsche Börse’s electronic platform, Xetra. Important insights were gained from the microstructure literature during Xetra’s planning period (1994-1997), and Xetra’s implementation marked a huge step forward for Germany’s equity markets. Nevertheless, academic research and the design of a real-world marketplace remain works in progress.