Market Microstructure and Liquidity

In Module 1 you learned how an order book works. In reality, your order’s path is far more winding. Between the tap in your app and the execution there can be several venues, algorithms and market makers. This lesson looks into the engine room of modern markets – because understanding it explains what trading really costs.

A fragmented market#

Stocks used to trade mainly on their home exchange. Today trading is spread across many venues:

• Exchanges with public order books – NYSE, Nasdaq, Cboe and more than a dozen others in the US alone.
• Alternative trading systems, including dark pools, where institutions trade blocks without displaying orders.
• Off-exchange execution by wholesale market makers, which handle a large share of US retail orders directly.

That prices stay nearly identical everywhere is thanks to arbitrage algorithms that exploit and close any price gap within milliseconds. US rules (Regulation NMS) also require trades to execute at or better than the best displayed price across exchanges.

Who supplies liquidity#

Market makers#

Market makers continuously quote buy and sell prices. They earn the spread but carry the risk of holding positions they can’t offload immediately. Their biggest enemy is better-informed traders: someone who buys just before a price jump leaves the market maker with a loss. So market makers widen spreads when they sense uncertainty.

High-frequency trading#

A large share of trading today is done by computers that react in microseconds – high-frequency trading (HFT). Estimates put its share of US equity volume at around half. Many HFT firms are effectively electronic market makers.

The record is mixed:

• Benefits: spreads on large stocks have fallen dramatically over recent decades. For individuals, trading has never been cheaper.
• Drawbacks: HFT liquidity is fleeting. In stressful moments algorithms often withdraw their quotes, and seemingly deep liquidity disappears. There’s also a costly arms race for speed, such as servers placed right next to exchange computers (co-location).

The true cost of an order#

For professionals, trading costs have three layers:

1. Fees: commissions and exchange fees – visible on your statement.
2. Spread: half the bid-ask gap on each buy or sell.
3. Market impact: the price move your own order causes. Negligible for most individuals, often the largest cost for big funds.

That’s why institutions use algorithms to slice large orders into small pieces, spread them through the day (for example following average volume, VWAP), trade in dark pools or in closing auctions. Some orders show only a fraction of their true size in the book (iceberg orders).

Payment for order flow and best execution#

Brokers must seek the most favourable terms reasonably available for client orders – the principle of best execution. What “best” means is open to interpretation: price, cost, speed and likelihood of execution all have to be weighed.

A contested practice is payment for order flow: wholesalers pay brokers to route retail orders to them. Retail orders are attractive because, on average, individuals don’t trade on superior information. In the US the model is legal and underpins many commission-free brokers; wholesalers often fill orders slightly better than the public quote (price improvement). Critics argue that real competition for each order on exchanges could deliver better prices. The EU has banned the practice since mid-2026.

Liquidity is a fair-weather friend#

One of the key lessons of market microstructure: liquidity is scarcest exactly when you need it most. In calm times spreads are tight and order books deep. In a panic, liquidity providers withdraw, spreads widen and even modest orders move prices sharply. That’s especially true for small caps, thinly traded bonds and exotic ETFs – and it’s one more reason never to be forced to sell in a panic.

Summary#

Modern markets are a network of exchanges, alternative venues, dark pools and market makers held together by fast algorithms. High-frequency trading has made trading cheaper, but its liquidity is fleeting. The true cost of an order consists of fees, spread and market impact. And liquidity disappears just when everyone wants out at once.