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Market Microstructure: Facts and Institutions
1.1 Introduction
Question: What determines a price in market?
Scenario: One of the oldest trading schemes in the economics literature is the Walrasian auction (Walras 1874) supervised by a Walrasian auctioneer. In this simplified trading mechanism, agents wishing to trade an asset (some agents want to buy the asset, others want to sell it) submit the demands and supplies and then announces a first potential trading price. Knowing this price, agents revise their supplies and demands, which leads to a revision of the price by the auctioneer. At the end of this process, a market clearing price is obtained, which equates aggregate supply and demand. Trades between buyers and sellers only take place when an equilibrium price has been reached.
• Rational Expectation Literature:
– Properties of the equilibrium price are relevant,
– Equilibrium price is determined such that the supply and demand are equal.
• Walrasian Auctioneer:
(a) Each trader submits his demand to the auctioneer.
(b) Auctioneer announces a potential price and traders determine their optimal
1demand at that price.
(c) An equilibrium prevails where each trader submits his optimal order at the equilibrium price and at that price the quantity supplied is equal to the quantity demanded.
Baumol (1965) contrasts the Walrasian market with the NYSE pointing out two significant ways in which they differ. First, the NYSE does not depend on the invisible hand but assigns a market maker called the `specialist' to operate the market. Second, the Walrasian market is a `call' market in that it aggregates buy and sell orders to determine the clearing price and then `calls' the market at the that price; while the NYSE is a continuous market except for the opening each day (in which it is a call market). The important property of the continuous market is that matching orders may not always exist for orders as they arrive. Such a market has the potential of becoming unstable with wide price fluctuations unless a stabilizing `reservoir' is available to soak up the imbalance in the order flow. When the price is affected by the trading mechanism in this manner, it is no longer an unbiased estimator of true value as the EMH requires but is biased by an amount that is attributable to the market design.
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