Traditional asset pricing theory and investment analysis treat the process of price formation as a black box. The actual structure of financial markets does not play a role, and frictions and transaction costs are disregarded. These issues, and market liquidity in particular, are of enormous practical importance. This is evidenced by the great attention regulators pay to issues of financial market structure (e.g. the MiFID directive of the EU), as well as by the attention market participants pay to trading costs. In recent years, many new markets have been created in an attempt to reduce transaction costs (e.g. the ATS in the US or Chi-X and Turquoise in Europe). Much of the order volume in today's markets is generated by computers rather than by human traders. This phenomenon (termed algorithmic trading or high frequency trading) has been accused of destabilizing markets, most importantly in conjunction with the infamous 2010 “flash crash”.
The branch of financial economics that deals with these issues is called market microstructure. This course provides an introduction into the institutional, theoretical and empirical foundations of market microstructure. It then applies these principles to several recent phenomena. We will discuss short selling restrictions, regulation and its effects on competition between market places, and algorithmic trading, to name but a few. The last chapter of the course will discuss relations between market microstructure and other areas of finance such as asset pricing and corporate finance.