Market microstructure is the study of how trading mechanisms produce observed prices, transaction costs, and liquidity. It examines the institutions and strategic behavior between an investor's decision to trade and the price at which that trade occurs.
Spreads and liquidity
The bid is the highest standing price at which a buyer is willing to trade, while the ask is the lowest standing price offered by a seller. Their difference is the bid-ask spread. Spreads can compensate liquidity providers for order-processing costs, inventory risk, and the possibility of trading against someone with better information.
Liquidity has several dimensions. A market can have high trading volume while still offering little depth near the current price. Depth measures how much can trade before prices move materially; immediacy measures how quickly a trade can be executed; resilience describes how quickly the order book recovers after a shock.
Information and price discovery
Orders can reveal information about private values or beliefs. A market maker who suspects that incoming traders are informed may widen spreads or adjust quotes. Through this process, private information becomes reflected in public prices, but the same transaction can also move prices because it consumes limited liquidity.
Observed price changes therefore mix information, inventory effects, order flow, and market rules. Market-microstructure models try to separate these mechanisms rather than treating every transaction price as an unmediated estimate of fundamental value.
Market design and empirical work
Exchange rules, tick sizes, order types, transparency, latency, and priority rules change trader incentives. A pattern measured under one market design may not transfer to another. Empirical microstructure work must account for the process that generated the data, including bid-ask bounce, asynchronous trading, and selection into different order types.
Cameron studied market microstructure as part of his academic work in financial economics.