Microstructure under the Microscope: Tools to Survive and Thrive in The Age of (Too Much) Information

Abstract

Market Microstructure is the investigation of the process and protocols that govern the exchange of assets with the objective of reducing frictions that can impede the transfer. In financial markets, where there is an abundance of recorded information, this translates to the study of the dynamic relationships between observed variables, such as price, volume and spread, and hidden constituents, such as transaction costs and volatility, that hold sway over the efficient functioning of the system. “My dear, here we must process as much data as we can, just to stay in business. And if you wish to make a profit you must process at least twice as much data.” - Red Queen to Alice in Hedge-Fund-Land. Necessity is the mother of all invention/creation/innovation, but the often forgotten father is frustration. In this age of (Too Much) Information, it is imperative to uncover nuggets of knowledge (signal) from buckets of nonsense (noise). To aid in this effort to extract meaning from chaos and to gain a better understanding of the relationships between financial variables, we summarize the application of the theoretical results from (Kashyap 2016b) to microstructure studies. The central concept rests on a novel methodology based on the marriage between the Bhattacharyya distance, a measure of similarity across distributions, and the Johnson Lindenstrauss Lemma, a technique for dimension reduction, providing us with a simple yet powerful tool that allows comparisons between data-sets representing any two distributions. We provide an empirical illustration using prices, volumes and volatilities across seven countries and three different continents. The degree to which different markets or sub groups of securities have different measures of their corresponding distributions tells us the extent to which they are different. This can aid investors looking for diversification or looking for more of the same thing. In Indian mythology, it is believed that in each era, God takes on an avatar or reincarnation to fight the main source of evil in that epoch and to restore the balance between good and bad. In this age of too much information and complexity, perhaps the supreme being needs to be born as a data scientist, conceivably with an apt nickname, the Infoman. Until higher powers intervene and provide the ultimate solution to completely eliminate information overload, we have to make do with marginal methods, such as this composition, to reduce information. As we wait for the perfect solution, it is worth meditating upon what superior beings would do when faced with a complex situation, such as the one we are in. It is said that the Universe is but the Brahma's (Creator's) dream. Research (Effort/Struggle) can help us understand this world; Sleep (Ease/Peace of Mind) can help us create our own world. A lesson from close by and down under: We need to “Do Some Yoga and Sleep Like A Koala”.