Market Microstructure and High-Frequency Trading: Price Discovery and Liquidity

Abstract

Market microstructure—the study of the trading process by which investors’ latent demands are translated into transactions and prices—has grown from a specialized subfield into a central area of financial economics, driven by the profound transformation of securities markets from floor-based human trading to electronic continuous-time auctions dominated by algorithmic and high-frequency traders. Kyle’s (1985) foundational model in Econometrica established that informed traders strategically exploit private information through dynamic order placement, while Glosten and Milgrom’s (1985) adverse selection model showed that market makers widen bid-ask spreads to compensate for trading against better-informed counterparties. The rise of high-frequency trading (HFT)—algorithmic trading at microsecond timescales—has generated intense debate about whether HFT improves or harms market quality, with evidence on both sides of the liquidity provision and price discovery questions. This paper reviews market microstructure theory, empirical evidence on bid-ask spreads and their determinants, the welfare effects of HFT on price discovery and market quality, and regulatory responses to HFT’s market structure implications.