We survey the literature analyzing the price formation and trading process, and the consequences of market organization for price discovery and welfare. We o er a synthesis of the theoretical microfoundations and empirical approaches. Within this framework, we confront adverse selection, inventory costs and market power theories to the evidence on transactions costs and price impact. Building on these results, we proceed to an equilibrium analysis of policy issues. We review the extent to which market frictions can be mitigated by such features of market design as the degree of transparency, the use of call auctions, the pricing grid, and the regulation of competition between liquidity suppliers or exchanges.

case of bilateral incomplete information ∗

We consider the effect of asymmetric information on the price formation process in a quote-driven market where one market maker receives a private signal on the security fundamental. A model is presented where market makers repeatedly compete in prices: at each stage a bid-ask auction occurs and the winner trades the security against liquidity traders. We show that at equilibrium the market is not strong-form efficient until the last stage. We characterize a reputational equilibrium in which the informed market maker will affect market beliefs, and possibly misleads them. At this equilibrium, a price leadership e¤ect arises, quotes are never equal to the expected value of the asset given the public information, the informed market maker expected payoff is positive and the rate of price discovery increases in the last stages of trade before the information becomes public.