What is Market Microstructure?

Understanding Market Microstructure

Market microstructure studies how trading mechanisms, order types, and participant behavior influence price formation. In FX, it explains spreads, slippage, and execution dynamics.

Key Components

Order books, liquidity providers, matching engines, and dealer inventories all shape price discovery. Knowledge of microstructure helps traders choose optimal order types and trading sessions.

Research Tools

Study execution reports, volume profiles, and order-flow analytics. Institutional desks often employ microstructure models to anticipate short-term price response.

FX‑Specific Nuances

• Last look: Some LPs can reject stale orders—good during spikes, bad for takers.
• Internalization: Brokers may match client flow in‑house, affecting spread and slippage.
• Session regimes: Liquidity and behavior differ sharply by session; adapt tactics.

Order Size and Impact

Price impact isn’t linear—doubling size can more than double slippage in thin markets. Split clips, seek liquid windows, and avoid sweeping the book unless urgency justifies the cost. Monitor realized impact to calibrate maximum order sizes per pair and session.

Practical Playbook

• Trade during liquid overlaps to minimize spread and impact.
• Use limits at known liquidity to improve entries; avoid chasing into thin pockets.
• Track slippage, rejections, and spread paid; switch venues if metrics drift.
• Downsize into news; wait for spreads to normalize before scaling.

Dealer inventory also matters: when dealers accumulate inventory, they shade quotes to attract flow on the other side, nudging short‑term price. Recognizing this behavior around large runs or at session ends helps explain mean‑reversion bursts and why spreads occasionally widen without headlines.

Hidden and conditional liquidity—icebergs, conditional orders at dealers—mean the visible book understates true capacity. Treat any single metric as incomplete and corroborate with price response and execution stats over time.