What Are Electronic Communication Networks (ECN)?

Today everyone who`s involved in operations on the US stock market knows about ECNs. But there are not many people who really understand the basic principles of ECNs. This article explains the most important things about ECN systems.

ECN is an automated computer trading system. The first ECN was INSTINET – a trading network established in 1969, long before the term ECN appeared in dictionaries. Most of the other ECNs (ISLAND, REDI, ARCHIPELAGO, BLOOMBERG, BRUT) have been built on the principles of the first ECN – INSTINET. New rules of order execution became a catalyst for the intensive ECN`s development. New rules were approved after a long discussion in the investors’ community, as well as in brokerage houses. The main goal of the new rules was the modification of the existing order execution algorithms so that every investor could get the best possible price by an order submission, whether he buys or sells shares. New rules were to terminate all market-makers` opportunities to gain extra profit from unfair order execution. ECNs manage this task in the best possible way. By the way, ECNs allow working on the stock market without market-makers more efficiently.

The first task of ECN systems is to execute buy orders by sell orders of equal volume. This process goes automatically, for example, if the system receives a sell order for 1000 shares of XYZ Inc. at $10 per share, it will look for the same buy order (i.e., the same amount of shares at a particular price).
Automated search of two equal orders is the fastest and the most effective way of fulfilling orders. By the way, FIFO execution principle (First In First Out) guarantees individual investors a fair execution not depending on personal trading volumes.

So, today ECNs work as a quasi-stock exchange. If an opposite order is not found in the system, an ECN uses the same algorithm as the NASDAQ does: it transfers the best available bid and offer to the NASDAQ. NASDAQ`s Level 2 information screens show this quotes under the name of the ECN. When the bid or offer of the ECN becomes the best among available on the NASDAQ, anyone who is following NASDAQ quotes, enters his opposite order at the same price which leads to the execution of the order, originally entered in the ECN.

Thus, ECN fulfills two functions: it is an electronic quasi-exchange and a market maker in the trading system NASDAQ. Under the rules of the Securities Commission (SEC), ECNs can be registered as an electronic stock exchange, i.e., they are officially recognized as stock exchanges.

ECNs` advantages
The main advantages are: anonymity, automated order execution and low costs. Buyers and sellers can put their orders into ECN and not worry that information about their activity will affect the market. There is completely no human factor in order execution, so far the electronic system accepts and executes all orders. ECNs not only speed up the trading process, but also spare investors money: they do not try to make extra cash on the difference between the price in order and the actual market price just like it happens on the way “broker-NASDAQ market-maker”.

Today many ECNs expand trading time by adding several trading hours before and after an open market session. It is obvious that in the near future trading through ECN will be available round the clock.

ECN`s disadvantages
Trading in ECNs is extremely efficient if you trade highly liquid stocks that have a lot of one-time buy and sell orders. That increases the probability of the presence of two active opposite equal orders in the system. It may be not a very good idea to trade less liquid stocks in ECNs. In this situation it`s better to send your orders to traditional market-makers of the NASDAQ.

By the way, the same shares can have different liquidity level in different ECNs.