Trading and Exchanges
The standard text on market microstructure and how orders get filled.
Summary
Larry Harris was chief economist of the Securities and Exchange Commission and wrote this comprehensive treatment of market microstructure for practitioners rather than for academics. It is long and covers the field completely.
The organising approach is to identify the participants and what each is trying to do. Harris classifies traders by motive: profit-motivated traders including informed traders, dealers, arbitrageurs and bluffers, and utility-motivated traders including investors, borrowers, hedgers and gamblers. He then shows that the returns to each group come from the others, and that understanding any market requires identifying who is paying whom.
The structural material covers order types and what each does, the difference between order-driven and quote-driven markets, continuous trading and call auctions, the mechanics of clearing and settlement, and the specific roles of brokers, dealers and exchanges. The analytical material covers liquidity and its measurement, transaction cost analysis, the bid-ask spread's components, volatility, informed trading and how dealers protect themselves against it, market manipulation and its forms, and market efficiency. Later sections cover market regulation and the arguments for and against specific rules. Harris writes clearly and the book assumes no mathematics beyond arithmetic. It dates from 2002 and predates the current fragmented electronic structure, but it remains the best single explanation of how trading works and who pays for it.
Key takeaways 7
- Every trader's returns come from other traders, so understanding a market requires identifying who is paying whom.
- Profit-motivated traders and utility-motivated traders have different objectives, and liquidity flows from the second group to the first.
- Liquidity is supplied by dealers who must be compensated for inventory risk and for trading against informed counterparties.
- Order-driven and quote-driven market structures allocate the costs of liquidity provision differently among participants.
- Transaction costs include the spread, the market impact of the order and the opportunity cost of unfilled orders, and the last is usually ignored.
- Manipulation takes specific identifiable forms, and Harris classifies them by mechanism rather than by intent.
- Market structure rules determine who bears the cost of liquidity rather than whether that cost exists.
Who should read it
Traders, institutional investors and anyone who needs to understand market mechanics and transaction costs without a mathematical treatment.
Where it sits in the reference 2
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