An electronic communication network (ECN) is a digital system that matches buyers and sellers looking to trade securities in the financial markets. · ECNs allow.
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- Where have you heard about electronic communication networks?
- Electronic Communication Network (ECN) Definition
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- Competition among Trading Venues: Information and Trading on Electronic Communications Networks
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Where have you heard about electronic communication networks?
Please note that corrections may take a couple of weeks to filter through the various RePEc services. Economic literature: papers , articles , software , chapters , books. FRED data. My bibliography Save this article. Barclay Terrence Hendershott D. Timothy McCormick. ECNs offer the advantages of anonymity and speed of execution, which attract informed traders. However, ECN trades have higher ex ante trading costs because market makers can preference or internalize the less informed trades and offer them better executions. More about this item Statistics Access and download statistics.
Corrections All material on this site has been provided by the respective publishers and authors. Louis Fed. Buyers and sellers connect to ECNs, either personally or through a brokerage, and enter a bid. These orders are then listed anonymously on the ECN's notebook, or order book, while the computer searches the entire system for a match, or a corresponding bid that matches the buyer's or seller's listed price. Once the match is found, the ECN executes the transaction. Since ECNs don't earn money on the spreads between buy and sell orders, as traditional brokerages and investment banks do, they rely on the sheer volume of trading through their networks to generate revenue.
Traditionally, ECNs were open only to other users on the same system, meaning that an order would wait on the ECN's order book until a corresponding bid was placed on the same system. However, in the early s the use of such closed systems was declining in popularity. ECNs like Archipelago began offering open trading systems in which unmatched orders were transferred to and listed on other trading systems.
In this way, ECNs can offer the greatest amount of liquidity to investors, allowing them to complete their order as quickly as possible. To boost the level of liquidity, many ECNs began to pool their resources using inter-ECN links and powerful order routing and search engine technology to sift through many ECNs simultaneously, seeking out order matches. Since investors typically place a premium on liquidity, the pressure on ECNs to open their systems was likely to intensify. In the face of heating competition, differentiation has come to drive competition in the ECN industry.
Some, such as Instinet, sought to capture the institutional investment market for electronic trading. Other ECNs, like Island, settled on the day trading market, which, while humbled, was still vibrant in the early s.
Electronic Communication Network (ECN) Definition
Meanwhile, to hedge their bets some of the major brokerage houses threw their money and support behind ECNs. Merrill Lynch, J. Senate Banking Securities Subcommittee, praising ECNs with ushering in "a rapid and sweeping democratization of the markets.
Thus, Instinet was more of a private system that catered to established investors, rather than to the more wide-open customer base served by modern ECNs. On the heels of a NASDAQ trading scandal in the mids — in which market makers were accused of conspiracy to skim profits by refusing to carry out unprofitable orders and by filling orders at prices that didn't meet buyers' expectations — the Securities and Exchange Commission SEC issued new order handling rules in , requiring all market makers to publish their orders on NASDAQ.
As a result of this ruling, the activities of the exclusive electronic trading networks like Instinet were forced into public view, and the modern ECN industry was born. The emergence of major ECNs coincided, happily enough, with the day-trading phenomena of the late s. This worked out perfectly for ECNs, since day traders typically were nontraditional investors with no solid roots in, or relationships with, the large brokerages. Instead, day traders were looking for quick and cheap ways to place a flurry of orders and reap a quick profit. Thus, the market conditions were ripe for new investment vehicles like ECNs to grab a piece of the action.
By late , only a dozen or so ECNs were in operation. However, the floodgates were ready to open during the early s, unleashing many new ECNs that sought to grab a piece of the market and carve out a distinct competitive niche.
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At the same time, however, analysts generally agreed that the field could not sustain such a glut of competitors over time, and the industry was expected to ripen for consolidation rather quickly. One factor driving the influx of new ECNs was the relatively low barrier to market entry. Indeed, several leading ECNs even filed with the SEC to acquire exchange status themselves, which set off a small war with the traditional exchanges.
Island and NexTrade Holdings Inc. Upon assuming exchange status, ECNs would enjoy direct access to the National Market System linking all stock exchanges, while having their quotations listed alongside those of other exchanges across the nation. At first blush, this complaint from a system that trafficked 2 billion shares per day against an ECN that moved million daily shares looked incongruous, but it was in fact indicative of the exchanges' fear of ECNs' potential — particularly that of NASDAQ, which was the most immediately threatened.
The move toward exchange status had a pragmatic component as well. Following the tech market bust in , day trading suffered a tremendous blow. While it hardly disappeared from the scene, a large portion of the natural customer base that ECNs enjoyed on their way to success was no longer a sure bet. Therefore, taking advantage of the benefits of exchange status would help to maintain them during the post-bull market. Exchange status also is the doorway to the extremely lucrative business of packaging and selling market data like stock prices.
This is a coveted benefit, particularly since ECNs still suffer a competitive disadvantage when it comes to liquidity. This added up to nearly one-third of total NYSE shares and half of the exchange's trading volume, including some of the biggest blue-chip stocks. This rule clearly restricted the range of business ECNs could conduct, and excluded them from some of the most widely demanded stocks on the NYSE. NASDAQ received approval in late to introduce its SuperMontage, a quote aggregation and execution system that will display the three best prices for a given stock and provide a vehicle by which customers' orders can be routed to any venue for completing the transaction.
ECNs also led the way in moving trading systems away from the antiquated practice of listing stock prices with fractions.
Competition among Trading Venues: Information and Trading on Electronic Communications Networks
Island ECN began the decimalization of its stock listings in July , prompting other trading systems to follow suit. In this way, listed stock prices appeared in the form of dollars and cents.
This practice also was competitively advantageous to ECNs in their struggle against the market makers. Market makers, earning margins by the spread between the buy and sell price, could use the fraction system to artificially pad those spreads. While this effectively adds up to less than seven cents a share — or one-sixteenth of a dollar, the smallest trading "tick" available in the fraction system — those pennies add up to astronomical sums over several million trades.
And given that ECNs survive by the few pennies or less per share they charge for trades through their systems, switching to the more accurate decimal systems and pressuring the exchanges to do likewise closes off a major competitive rift between ECNs and market makers. In the early s, analysts were mixed in their predictions for the future of ECNs. Some felt they would drive securities trading while others insisted they would be phased out once the major exchanges co-opted their advantages.
However, all agree that ECNs have been a major force in driving innovation in securities trading, and that the future of the markets will reflect the ECN influence. Der Hovanesian, Mara; and Emily Thornton. October 23, July Guerra, Anthony. October Jovin, Ellen. June 1,