Electronic communication network

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An electronic communication network (ECN) is a type of computerized forum or network that facilitates the trading of financial products outside traditional stock exchanges. An ECN is generally an electronic system accessed by an electronic trading platform that widely disseminates orders entered by market makers to third parties and permits the orders to be executed against them in whole or in part. The primary products that are traded on ECNs are stocks and currencies. ECNs are generally passive computer-driven networks that internally match limit orders and charge a very small per share transaction fee (often a fraction of a cent per share). [1]

Contents

The first ECN, Instinet, was created in 1969. ECNs increase competition among trading firms by lowering transaction costs, giving clients full access to their order books, and offering order matching outside traditional exchange hours.[ citation needed ] ECNs are sometimes also referred to as alternative trading systems or alternative trading networks.

History

The term ECN was first used in the 1970s by the U.S. Securities and Exchange Commission (SEC) to define, "any electronic system that widely disseminates to third parties orders entered therein by an exchange market maker or OTC market maker, and permits such orders to be executed against it in whole or in part". [2] The first ECN, the Instinet, was released in 1969 and provided an early application of the advances in computing. [3] The spread of ECNs was encouraged through changes in regulatory law set forth by the SEC, and in 1975 the SEC adopted the Securities Acts Amendments of 1975, encouraging the "linking of all markets for qualified securities through communication and data processing facilities". [4]

ECNs have complicated stock exchanges through their interaction with NASDAQ. One of the key developments in the history of ECNs was the NASDAQ over-the-counter quotation system. NASDAQ was created following a 1969 American Stock Exchange study which estimated that errors in the processing of handwritten securities orders cost brokerage firms approximately $100 million per year. The NASDAQ system automated such order processing and provided brokers with the latest competitive price quotes via a computer terminal. In March 1994, a study by two economists, William Christie and Paul Schultz, noted that NASDAQ bid–ask spreads were larger than was statistically likely, indicating "We are unable to envision any scenario in which 40 to 60 dealers who are competing for order flow would simultaneously and consistently avoid using odd-eighth quotes without an implicit agreement to post quotes only on the even price fractions. However, our data do not provide direct evidence of tacit collusion among NASDAQ market makers".

These results led to an antitrust lawsuit being filed against NASDAQ. As part of NASDAQ's settlement of the antitrust charges, NASDAQ adopted new order handling rules that integrated ECNs into the NASDAQ system. Shortly after this settlement, the SEC adopted Regulation ATS, which permitted ECNs the option of registering as stock exchanges or else being regulated under a separate set of standards for ECNs. [5] [6]

At that time major ECNs that became active were Instinet and Island (part of Instinet was spun off, merged with Island into Inet, and acquired by NASDAQ), Archipelago Exchange (which was acquired by the NYSE) and Brut (now acquired by NASDAQ).

ECNs enjoyed a resurgence after the adoption of SEC Regulation NMS, which required "trade through" protection of orders in the market, regardless of where those orders are placed.

In the past, many ECNs were "closed book"—i.e., allowing participants to interact only with other participants in that network. However, increasingly ECNs have adopted an "open book" format, addressing the potential fragmented liquidity by integrating orders with those of other ECNs or market makers, thus increasing the overall pool of orders. [7]

Function

ECNs are used as stock exchanges for off-the-floor trading. [8] To trade with an ECN, one must be a subscriber or have an account with a broker that provides direct access trading. ECN subscribers can enter orders into the ECN via a custom computer terminal or network protocols. The ECN will then match contra-side orders (i.e. a sell-order is "contra-side" to a buy-order with the same price and share count) for execution. The ECN will post unmatched orders on the system for other subscribers to view.[ citation needed ] With ECN, buyers and sellers are able to trade anonymously, [9] [10] with the trade execution reports listing the ECN as the party.

ECNs allow its customers to trade outside traditional trading hours. [11] Some ECN brokers may offer additional features to subscribers such as negotiation, reserve size, and pegging, and may have access to the entire ECN book (as opposed to the "top of the book") that real-time market data regarding depth of trading interest.[ citation needed ] ECNs are also considered to be effective for handling small orders. [10]

ECNs are generally facilitated by electronic negotiation, a type of communication between agents that allows cooperative and competitive sharing of information to determine a proper price.

Negotiation types

The most common paradigm is the electronic auction type. As of 2005, most e-business negotiation systems can only support price negotiations. Traditional negotiations typically include discussion of other attributes of a deal, such as delivery terms or payment conditions. This one-dimensional approach is one of the reasons why electronic markets struggle for acceptance. Multiattributive and combinatorial auction mechanisms are emerging to allow further types of negotiation.

Support for complex multi-attribute negotiations is a critical success factor for the next generation of electronic markets and, more generally, for all types of electronic exchanges. This is what the second type of electronic negotiation, namely Negotiation Support, addresses. While auctions are essentially mechanisms, bargaining is often the only choice in complex cases or those cases where no choice of partners is given. Bargaining is a hard, error-prone, ambiguous task often performed under time pressure. Information technology has some potential to facilitate negotiation processes which are analyzed in research projects/prototypes such as INSPIRE, Negoisst or WebNS.

The third type of negotiation is automated argumentation, where agents exchange not only values, but also arguments for their offers/counter-offers. This requires agents to be able to reason about the mental states of other market participants.

Technologies

One research area that has paid particular attention to modeling automated negotiations is that of autonomous agents. If negotiations occur frequently, possibly on a minute per minute basis in order to schedule network capacity, or negotiation topics can be clearly defined it may be desirable to automate this coordination.

Automated negotiation is a key form of interaction in complex systems composed of autonomous agents. Negotiation is a process of making offers and counteroffers, with the aim of finding an acceptable agreement. During negotiation, each offer is based on its own utility and expectation of what other. This means that a multi-criteria decision making is need to be taken for each offer.

In the stock market

For stock trading, ECNs exist as a class of SEC-permitted alternative trading systems (ATS). [12] As an ATS, ECNs exclude broker-dealers' internal crossing networks – i.e., systems that match orders in private using prices from a public exchange.

ECNs, as alternative trading systems, have increased competition with institutional trading systems. Alternative trading systems have been found to have lower execution costs, however as new ECNs emerge, some of this cost reduction has dissipated. [13] Simultaneously, the growth of ECNs has been found to disrupt institutional trading. An analysis of impact of ECNs on NASDAQ found "tighter spreads, greater depths, and less concentrated markets". [14] ECNs provide historical orders and price data to subscribers. As a result, ECNs compete through their ability to attract "more informed orders" during "periods of high volume and return volatility". [15] Professor Terrence Hendershott argues that today "ECN's capture 40% of the volume in NASDAQ securities", and are considerably changing the securities trading market. [16]

ECNs' transactions can be completed without broker-dealers. [9] ECNs have influenced the stock market by eliminating dealer functions in order-matching. With the automation of orders on mass scale, the role of intermediary traders has been reconfigured. While the ECNs do not execute decision-making algorithms to the extent of algorithmic trading, nevertheless they have impacted the role of human traders in financial exchange.

Fee structure

ECN's fee structure can be grouped in two basic structures: a classic structure and a credit (or rebate) structure. Both fee structures offer advantages of their own. The classic structure tends to attract liquidity removers while the credit structure appeals to liquidity providers. However, since both removers and providers of liquidity are necessary to create a market, ECNs must choose their fee structures carefully.

In a credit structure ECNs make a profit from paying liquidity providers a credit while charging a debit to liquidity removers. Credits range from $0.002 to $0.00295 per share for liquidity providers, and debits from $0.0025 to $0.003 per share for liquidity removers. The fee can be determined by the monthly volume provided and removed, or by a fixed structure, depending on the ECN. This structure is common on the NASDAQ market. NASDAQ Price List. Traders commonly quote the fees in millicents or mils (e.g. $0.00295 is 295 mils).

In a classic structure, the ECN will charge a small fee to all market participants using their network, both liquidity providers and removers. They also can attract volume to their networks by giving lower prices to large liquidity providers. Fees for ECNs that operate under a classic structure range from $0 to $0.0015, or even higher depending on each ECN. This fee structure is more common in the NYSE, however recently some ECNs have moved their NYSE operations into a credit structure.

Currency trading

The first ECN for internet currency trading was New-York based Matchbook FX formed in 1999. Back then, all the prices were created & supplied by Matchbook FX's traders/users, including banks, within its ECN network. This was quite unique at the time, as it empowered buy-side FX market participants, historically always "price takers", to finally be price makers as well. Today, multiple FX ECNs provide access to an electronic trading network, supplied with streaming quotes from the top tier banks in the world. Their matching engines perform limit checks and match orders, usually in less than 100 milliseconds per order. The matching is quote driven and these are the prices that match against all orders.

Spreads are discretionary but in general multibank competition creates 1-2 pip spreads on USD Majors and Euro Crosses. The order book is not a routing system that sends orders to individual market makers. It is a live exchange type book working against the best bid/offer of all quotes. By trading through an ECN, a currency trader generally benefits from greater price transparency, faster processing, increased liquidity and more availability in the marketplace. Banks also reduce their costs as there is less manual effort involved in using an ECN for trading.

See also

Related Research Articles

<span class="mw-page-title-main">Nasdaq</span> American stock exchange

The Nasdaq Stock Market is an American stock exchange based in New York City. It is the most active stock trading venue in the U.S. by volume, and ranked second on the list of stock exchanges by market capitalization of shares traded, behind the New York Stock Exchange. The exchange platform is owned by Nasdaq, Inc., which also owns the Nasdaq Nordic stock market network and several U.S.-based stock and options exchanges. Although it trades stock of healthcare, financial, media, entertainment, retail, hospitality, and food businesses, it focuses more on technology stocks. The exchange is made up of both American and foreign firms, with China and Israel being the largest foreign sources.

<span class="mw-page-title-main">Day trading</span> Buying and selling financial instruments within the same trading day

Day trading is a form of speculation in securities in which a trader buys and sells a financial instrument within the same trading day, so that all positions are closed before the market closes for the trading day to avoid unmanageable risks and negative price gaps between one day's close and the next day's price at the open. Traders who trade in this capacity are generally classified as speculators. Day trading contrasts with the long-term trades underlying buy-and-hold and value investing strategies. Day trading may require fast trade execution, sometimes as fast as milli-seconds in scalping, therefore direct-access day trading software is often needed.

A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the difference, which is called the bid–ask spread or turn. This stabilizes the market, reducing price variation (volatility) by setting a trading price range for the asset.

<span class="mw-page-title-main">Securities Exchange Act of 1934</span> 1934 U.S. legislation establishing rules and regulatory bodies for financial markets

The Securities Exchange Act of 1934 is a law governing the secondary trading of securities in the United States of America. A landmark piece of wide-ranging legislation, the Act of '34 and related statutes form the basis of regulation of the financial markets and their participants in the United States. The 1934 Act also established the Securities and Exchange Commission (SEC), the agency primarily responsible for enforcement of United States federal securities law.

The Small-Order Execution System (SOES) was a system to facilitate clearing trades of low volume on Nasdaq. It has been phased out and is no longer necessary.

A crossing network is an alternative trading system (ATS) that matches buy and sell orders electronically for execution without first routing the order to an exchange or other public displayed market such as an electronic communication network (ECN). Such crossing networks are a type of dark pool that employ computerized systems to match buyers and sellers of large blocks of shares without using a stock exchange. The advantage of the crossing network is the ability to execute a large block order without impacting the public quote and avoidance of market impact.

Best execution refers to the duty of an investment services firm executing orders on behalf of customers to ensure the best execution possible for their customers' orders. Some of the factors the broker must consider when seeking best execution of their customers' orders include: the opportunity to get a better price than what Is currently quoted, and the likelihood and speed of execution.

<span class="mw-page-title-main">Extended-hours trading</span> Stock trading outside of trading hours

Extended-hours trading is stock trading that happens either before or after the trading day regular trading hours (RTH) of a stock exchange, i.e., pre-market trading or after-hours trading.

Direct market access (DMA) in financial markets is the electronic trading infrastructure that gives investors wishing to trade in financial instruments a way to interact with the order book of an exchange. Normally, trading on the order book is restricted to broker-dealers and market making firms that are members of the exchange. Using DMA, investment companies and other private traders use the information technology infrastructure of sell side firms such as investment banks and the market access that those firms possess, but control the way a trading transaction is managed themselves rather than passing the order over to the broker's own in-house traders for execution. Today, DMA is often combined with algorithmic trading giving access to many different trading strategies. Certain forms of DMA, most notably "sponsored access", have raised substantial regulatory concerns because of the possibility of a malfunction by an investor to cause widespread market disruption.

Regulation National Market System is a 2005 US financial regulation promulgated and described by the Securities and Exchange Commission (SEC) as "a series of initiatives designed to modernize and strengthen the National Market System for equity securities". The Reg NMS is intended to assure that investors receive the best (NBBO) price executions for their orders by encouraging competition in the marketplace. Some contend that the rule has contributed to the rise of high-frequency trading, which is sometimes regarded as controversial.

In finance, a dark pool is a private forum for trading securities, derivatives, and other financial instruments. Liquidity on these markets is called dark pool liquidity. The bulk of dark pool trades represent large trades by financial institutions that are offered away from public exchanges like the New York Stock Exchange and the NASDAQ, so that such trades remain confidential and outside the purview of the general investing public. The fragmentation of electronic trading platforms has allowed dark pools to be created, and they are normally accessed through crossing networks or directly among market participants via private contractual arrangements. Generally, dark pools are not available to the public, but in some cases, they may be accessed indirectly by retail investors and traders via retail brokers.

<span class="mw-page-title-main">Electronic trading platform</span> Software for trading financial products

In finance, an electronic trading platform also known as an online trading platform, is a computer software program that can be used to place orders for financial products over a network with a financial intermediary. Various financial products can be traded by the trading platform, over a communication network with a financial intermediary or directly between the participants or members of the trading platform. This includes products such as stocks, bonds, currencies, commodities, derivatives and others, with a financial intermediary such as brokers, market makers, Investment banks or stock exchanges. Such platforms allow electronic trading to be carried out by users from any location and are in contrast to traditional floor trading using open outcry and telephone-based trading. Sometimes the term trading platform is also used in reference to the trading software alone.

Instinet Incorporated is an institutional, agency-model broker that also serves as the independent equity trading arm of its parent, Nomura Group. It executes trades for asset management firms, hedge funds, insurance companies, mutual funds and pension funds. Headquartered in New York City, the company provides sales trading services and trading technologies such as the Newport EMS, algorithms, trade cost analytics, commission management, independent research and dark pools.

High-frequency trading (HFT) is a type of algorithmic trading in finance characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. While there is no single definition of HFT, among its key attributes are highly sophisticated algorithms, co-location, and very short-term investment horizons in trading securities. HFT uses proprietary trading strategies carried out by computers to move in and out of positions in seconds or fractions of a second.

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Island ECN was one of the first electronic communication networks established for the trading equities in the United States. Founded in 1996 by Datek Securities veterans Jeff Citron and Joshua Levine, Island executed its first trades in 1997.

MT4 ECN Bridge is a technology that allows a user to access the interbank foreign exchange market through the MetaTrader 4 (MT4) electronic trading platform. MT4 was designed to allow trading between a broker and its clients, so it did not provide for passing orders through to wholesale forex market via electronic communication networks (ECNs). In response, a number of third-party software companies developed Straight-through processing bridging software to allow the MT4 server to pass orders placed by clients directly to an ECN and feed trade confirmations back automatically.

Direct Edge was a stock exchange operating two separate platforms, EDGA Exchange and EDGX Exchange. It was based in Jersey City, New Jersey.

<span class="mw-page-title-main">Bill Lupien</span> American businessman (1941–2021)

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<span class="mw-page-title-main">IEX</span> U.S.-based stock exchange

Investors Exchange (IEX) is a stock exchange in the United States. It was founded in 2012 in order to mitigate the effects of high-frequency trading. IEX was launched as a national securities exchange in September 2016. On October 24, 2017, it received regulatory approval from the U.S. Securities and Exchange Commission (SEC) to list companies. IEX listed its first public company, Interactive Brokers, on October 5, 2018. The exchange said that companies would be able to list for free for the first five years, before a flat annual rate of $50,000. On September 23, 2019, it announced it was leaving its listing business.

References

  1. ↑ Lemke and Lins, Soft Dollars and Other Trading Activities, §2:27 (Thomson West, 2013-2014 ed.).[ page needed ]
  2. ↑ "Regulation NMS SEC Act Release No 51808" (PDF).
  3. ↑ Johnson, Stafford (2014). Equity Markets and Portfolio Analysis. John Wiley & Songs. ISBN   978-1-118-20268-5.[ page needed ]
  4. ↑ "The 1975 SEC Act Amendments" (PDF).
  5. ↑ Christie, William G. and Schultz, Paul H. "Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?" The Journal of Finance 49:5 (December 1994), pp. 1813–1840.
  6. ↑ "Statement on the Structure of the Nasdaq Stock Market" Archived 2010-06-03 at the Wayback Machine , Financial Economists Roundtable, September 18, 1995.
  7. ↑ Lemke and Lins, Soft Dollars and Other Trading Activities, §2:27 (Thomson West, 2013 ed.)[ page needed ]
  8. ↑ "Stock exchange". Britannica. Retrieved 2020-07-29.
  9. 1 2 "How Do Electronic Communications Networks Relate to Stock Trading?". dummies.com. Retrieved 2020-08-04.
  10. 1 2 Fabozzi & Drake 2009 , p. 655
  11. ↑ Chen, James. "After-Hours Trading". Investopedia. 2020-04-15 15. Retrieved 2020-08-03.
  12. ↑ "ECN (electronic communication network)". deutsche-boerse.com. Archived from the original on 2022-06-24. Retrieved 2020-07-29.
  13. ↑ Conrad, Jennifer (2003). "Institutional Trading and Alternative Trading Systems". Journal of Financial Economics. 70 (1): 99–134. doi:10.1016/s0304-405x(03)00143-0.
  14. ↑ Fink, Jason (2006). "Competition on the NASDAQ and the Growth of Electronic Communication Networks". Journal of Banking & Finance. 30 (9): 2537–2559. doi:10.1016/j.jbankfin.2005.10.009.[ page needed ]
  15. ↑ Barclay, Michael. "Electronic Communications Networks and Market Quality". SSRN Electronic Journal.
  16. ↑ Hendershott, T (2003). "Electronic Trading in Financial Markets" (PDF).{{cite journal}}: Cite journal requires |journal= (help)[ page needed ]

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