New Research Offers a Clear Overview of How Market Microstructure Is Regulated

Market microstructure might sound like an abstract academic term, but it plays a central role in how modern financial markets actually function. It covers the nuts and bolts of trading: how markets are organized, how trades are executed, who intermediates those trades, and how all of this is regulated. A new research article takes a deep and systematic look at this topic, offering a broad overview of how market microstructure regulation works, particularly in equity, options, and fixed-income markets.

The research is authored by Chester Spatt of Carnegie Mellon University and Thomas Ernst of the University of Maryland and appears in the Annual Review of Financial Economics. Their goal is not to argue for a single reform or policy change, but to clearly explain why market microstructure is regulated so heavily, how those regulations differ across markets, and what trade-offs regulators face when designing rules for increasingly complex trading environments.

What Market Microstructure Really Means

At its core, market microstructure refers to the design and organization of trading markets. This includes how orders are submitted, how prices are determined, how liquidity is provided, and how information flows between buyers and sellers. It also includes the role of brokers, market makers, trading platforms, and regulators, all of whom influence how smoothly and fairly markets operate.

Unlike traditional macro-level finance topics, market microstructure focuses on the mechanics of trading itself. Small design choices—such as minimum tick sizes or routing rules—can significantly affect liquidity, transaction costs, and investor outcomes.

Why Regulation Is So Central to Market Design

The researchers emphasize that market microstructure is heavily regulated for very specific reasons. Trading markets are shaped by externalities, adverse selection, and moral hazard. Left entirely on their own, markets may evolve in ways that benefit certain participants at the expense of others, especially retail investors.

Because of these risks, regulators impose rules to limit conflicts of interest, protect investors, and ensure markets remain fair, orderly, and efficient. The paper explains that regulation is not uniform across all markets, because different asset classes involve different trading behaviors, liquidity conditions, and risk profiles.

Different Markets, Different Regulatory Regimes

One of the key points in the article is that equity markets, options markets, and fixed-income markets each operate under distinct regulatory frameworks.

Equity markets are highly fragmented, with trades spread across exchanges, alternative trading systems, and internalizers.
Options markets involve more complex contracts and risk exposures, requiring specialized rules.
Fixed-income markets are often less transparent and more dealer-driven, with fundamentally different liquidity dynamics.

These differences mean that a rule that works well in one market may be ineffective—or even harmful—in another.

The Role of Brokers and Market Makers

A large portion of the research focuses on intermediaries, especially brokers and market makers. Brokers are responsible for routing customer orders, while market makers provide liquidity by standing ready to buy or sell securities.

Regulation places specific responsibilities on these intermediaries, particularly when they act on behalf of customers. Issues such as conflicts of interest, compensation structures, and incentives for routing orders are central to the regulatory discussion.

The authors also examine how brokers and platforms price their services and how regulators oversee these pricing models.

Best Execution and Order Protection Rules

Among the most important regulatory concepts discussed is best execution. Brokers are required to seek the most favorable terms reasonably available when executing customer orders. This obligation goes beyond price alone and includes factors such as speed, likelihood of execution, and overall transaction cost.

Closely related are order protection rules, particularly those established under Regulation National Market System (Reg NMS) in the United States. These rules are designed to prevent “trade-throughs,” where an order is executed at a worse price than one publicly available on another venue.

Payment for Order Flow and Market Incentives

The paper also explores payment for order flow, a controversial practice in which brokers receive compensation for routing orders to specific trading venues or market makers. While this can lower explicit costs for investors, it also raises concerns about whether brokers are always prioritizing best execution.

This issue has become increasingly important as retail trading has grown and as zero-commission trading models have become widespread.

Tick Sizes, Access Fees, and Auctions

Several other technical but influential features of market design are covered in detail:

Tick size, or the minimum price increment for trading, affects liquidity and competition.
Access fees charged by trading venues influence where orders are routed.
Auctions, including opening and closing auctions, play a crucial role in price discovery and market stability.

These features may seem minor, but the research shows how deeply they shape trading outcomes.

Transparency and Short-Selling Restrictions

Transparency is another major regulatory concern. The authors distinguish between pre-trade transparency, which reveals information about orders before execution, and post-trade transparency, which involves reporting completed trades.

While transparency can improve fairness and price discovery, too much transparency can reduce liquidity in some markets, especially fixed-income trading.

The article also discusses short-selling restrictions, including temporary bans during periods of market stress, and how these rules interact with broader market design goals.

Fixed-Income Markets and Litigation Trends

Fixed-income markets receive special attention due to their unique structure and lower transparency. The authors highlight how regulation in these markets differs from equities and how market design continues to evolve.

They also point to the growing role of litigation in shaping regulatory outcomes, an increasingly important factor in how rules are interpreted and enforced.

Why This Research Matters

The authors argue that understanding market microstructure regulation is essential because it sits at the intersection of economics, law, and financial engineering. Regulators must balance efficiency, fairness, innovation, and stability—often with imperfect information.

As trading becomes more automated and fragmented, these regulatory questions are only becoming more important.

A Broader Look at Market Microstructure Today

Beyond this specific study, market microstructure research has gained renewed attention due to algorithmic trading, high-frequency trading, and the rise of complex electronic platforms. These developments make regulatory design even more challenging, reinforcing the importance of comprehensive overviews like this one.

Research Paper Reference
Ernst, T. H., & Spatt, C. S. (2025). Regulating Market Microstructure. Annual Review of Financial Economics. https://doi.org/10.1146/annurev-financial-112923-112656