Microstructure Modeling

Jonathan Kinlay has an interesting list of papers on market microstructure including his synopsis of each. Many of them applied a vector autoregression model to quote and trade data. The focus, however, is always the impact of the limit order book and the strategies for generating new bids and asks on the limit order book. All of the studies focused on the stock markets. Perhaps the most interesting of the papers is a recent one on Price Dynamics in a Markovian Limit Order Market from Rama Cont of Columbia, which provides a mostly analytical model for high frequency dynamics of prices and order flow with endogenous relationship between durations and price changes. Most of the data in this study came from 2008. According to that data, for certain DJ stocks, ~1.2% of observed bid-ask spreads were more than 1 tick, thus not as pertinent to the model. The average lifetime of such a spread appears to be only a couple of milliseconds. The model does consider order flow in the presence of market orders and cancellations, including the case when they dominate limit orders.

I also found a number of books on the subject (more after the jump).

There are actually a number of books on microstructure: (in no particular order) Market Microstructure Theory by O'Hara and Financial Markets and Trading: An Introduction to Market Microstructure and Trading Strategies (Wiley Finance) by Schmidt, Empirical Market Microstructure: The Institutions, Economics, and Econometrics of Securities Trading by Hasbrouck, and Trading and Exchanges: Market Microstructure for Practitioners by Harris.

O'Hara's (Market Microstructure Theory) is apparently the original, seminal volume on microstructure.

Schmidt's volume (Financial Markets and Trading: An Introduction to Market Microstructure and Trading Strategies (Wiley Finance)) covers 11+ models and various execution and trading strategies. His volume is also the most recently published of the 4 volumes and likely the most comprehensive.

Hasbrouck (Empirical Market Microstructure: The Institutions, Economics, and Econometrics of Securities Trading) is the inventor of one of the main models. He covers his own, variants of the Roll model, and a couple of other models. Prof. Hasbrouck also has a working paper with Gideon Saar on low latency which studies the merits of "market activity in the millisecond environment" including improved short-term volatility (especially with smaller stocks with an explicit caveat regarding the flash crash in May 2010), spreads, and displayed depth. Of particular interest in this working paper is a section studying the characteristics of "strategic runs", collections of order submissions, cancellations, and executions assumed to be part of some algorithm, by attempting to reverse engineer. They do so by linking submissions with their corresponding cancellations (through given reference numbers) and inferring resubmissions of the same order size within a second of cancellation to be from the same entity. Most of this cancellation and resubmission activity happens within 10ms.

Harris (Trading and Exchanges: Market Microstructure for Practitioners) provides a conceptual introduction without getting into any of the math and models behind microstructure.