Journal of Financial Markets 3 (2000) 205}258 Market microstructure: A survey夽 Ananth Madhavan* Marshall School of Business, University of Southern California, Los Angeles, CA 90089-1427, USA Abstract Market microstructure studies the process by which investors' latent demands are ultimately translated into prices and volumes. This paper reviews the theoretical, empirical and experimental literature on market microstructure relating to: (1) price formation, including the dynamic process by which prices come to impound information, (2) market structure and design, including the relation between price formation and trading protocols, (3) Transparency, the ability of market participants to observe information about the trading process, and (4) Applications to other areas of xnance including asset pricing, international "nance, and corporate "nance. 2000 Elsevier Science B.V. All rights reserved. JEL classixcation: G10; G34 Keywords: Market microstructure; Liquidity; Security prices; Transparency; Market design 1. Introduction The last two decades have seen a tremendous growth in the academic literature now known as market microstructure, the area of "nance that is 夽 I thank Avanidhar Subrahmanyam (editor), Rich Lyons and participants at the Market Microstructure Ph.D. seminar at Erasmus University for their comments. I have also bene"ted greatly from past discussions with Ian Domowitz, Margaret Forster, Larry Harris, Don Keim, and Seymour Smidt that are re#ected in this paper. Of course, any errors are entirely my own. Ananth Madhavan, 2000. * Corresponding author. Tel.: #1-213-740-6519; fax: #1-213-740-6650. E-mail address:
[email protected] (A. Madhavan). 1386-4181/00/$ - see front matter 2000 Elsevier Science B.V. All rights reserved. PII: S 1 3 8 6 - 4 1 8 1 ( 0 0 ) 0 0 0 0 7 - 0 206 A. Madhavan / Journal of Financial Markets 3 (2000) 205}258 concerned with the process by which investors' latent demands are ultimately translated into transactions. Interest in microstructure and trading is not new but the recent literature is distinguished by theoretical rigor and extensive empirical validation using new databases. Some recent books and articles o!er valuable summaries of important elements of the market microstructure literature. O'Hara's (1995) book provides an excellent and detailed survey of the theoretical literature in market microstructure. Harris (1999) provides a general conceptual overview of trading and the organization of markets in his text, but his focus is not on the academic literature. Lyons (2000) examines the market microstructure of foreign exchange markets. Survey articles emphasize depth over breadth, often focusing on a select set of issues. Keim and Madhavan (1998) survey the literature on execution costs, focusing on institutional traders. Coughenour and Shastri (1999) provide a detailed summary of recent empirical studies in four select areas: the estimation of the components of the bid}ask spread, order #ow properties, the Nasdaq controversy, and linkages between option and stock markets. A survey of the early literature in the area is provided by Cohen et al. (1986). This article provides a comprehensive review of the market microstructure literature, broadly de"ned to include theoretical, empirical and experimental studies relating to markets and trading. The paper is di!erentiated from previous surveys in its scope and its attempt to synthesize the diverse strands of the previous literature within the con"nes of a relatively brief article. My objective is to o!er some perspective on the literature for investors, exchange o$cials, policy makers and regulators while also providing a roadmap for future research endeavors. Interest in m