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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 that widely disseminates orders entered by market makers to third parties and permits the orders to be executed against in whole or in part. The primary products that are traded on ECNs are stocks and
currencies A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general def ...
. 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). The first ECN,
Instinet Instinet 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 fund ...
, 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. ECNs are sometimes also referred to as
alternative trading system Alternative trading system (ATS) is a US and Canadian regulatory term for a non-exchange trading venue that matches buyers and sellers to find counterparties for transactions. Alternative trading systems are typically regulated as broker-dealers r ...
s or alternative trading networks.


History

The term ECN was used by the 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 in whole or in part". The first ECN, the Instinet, was released in 1969 and provided an early application of the advances in computing. 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". 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 NYSE American, formerly known as the American Stock Exchange (AMEX), and more recently as NYSE MKT, is an American stock exchange situated in New York City. AMEX was previously a mutual organization, owned by its members. Until 1953, it was know ...
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 spread The bid–ask spread (also bid–offer or bid/ask and buy/sell in the case of a market maker) is the difference between the prices quoted (either by a single market maker or in a limit order book) for an immediate sale ( ask) and an immediate pur ...
s 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.Christie, William G. and Schultz, Paul H
"Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?"
''
The Journal of Finance ''The Journal of Finance'' is a peer-reviewed academic journal published by Wiley-Blackwell on behalf of the American Finance Association. It was established in 1946 and is considered to be one of the premier finance journals. The editor-in-chief i ...
'' 49:5 (December 1994), pp. 1813–1840.
At that time major ECNs that became active were
Instinet Instinet 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 fund ...
and
Island An island (or isle) is an isolated piece of habitat that is surrounded by a dramatically different habitat, such as water. Very small islands such as emergent land features on atolls can be called islets, skerries, cays or keys. An island ...
(part of Instinet was spun off, merged with Island into
Inet Inet was an electronic trading platform based on a system developed by Instinet in the 1970s that merged with Island ECN in 2002 and was subsequently acquired by NASDAQ in 2005. Inet, like other electronic communication networks, was an order-pai ...
, and acquired by NASDAQ), Archipelago Exchange (which was acquired by the
NYSE The New York Stock Exchange (NYSE, nicknamed "The Big Board") is an American stock exchange in the Financial District of Lower Manhattan in New York City. It is by far the world's largest stock exchange by market capitalization of its liste ...
) and Brut (now acquired by NASDAQ). ECNs enjoyed a resurgence after the adoption of SEC
Regulation NMS Regulation National Market System (or Reg NMS) is a US financial regulation promulgated and described by the United States Securities and Exchange Commission (SEC) as "a series of initiatives designed to modernize and strengthen the National Market ...
, 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.


Function

ECNs are used as stock exchanges for off-the-floor trading. 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 Order, ORDER or Orders may refer to: * Categorization, the process in which ideas and objects are recognized, differentiated, and understood * Heterarchy, a system of organization wherein the elements have the potential to be ranked a number of d ...
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. With ECN, buyers and sellers are able to trade anonymously, with the trade execution reports listing the ECN as the party. ECNs allow its customers to trade outside traditional trading hours. 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. ECNs are also considered to be effective for handling small orders. 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 An auction is usually a process of buying and selling goods or services by offering them up for bids, taking bids, and then selling the item to the highest bidder or buying the item from the lowest bidder. Some exceptions to this definition ex ...
type. As of 2005, most
e-business Electronic business (or "Online Business" or "e-business") is any kind of business or commercial transaction that includes sharing information across the internet. Commerce constitutes the exchange of products and services between businesses, grou ...
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 Electronic markets (or electronic marketplaces) are information systems (IS) which are used by multiple separate organizational entities within one or among multiple tiers in economic value chains. In analogy to the market concept which can be vie ...
struggle for acceptance. Multiattributive and
combinatorial auction A combinatorial auction is a type of smart market in which participants can place bids on combinations of discrete heterogeneous items, or “packages”, rather than individual items or continuous quantities. These packages can be also called lot ...
mechanisms are emerging to allow further types of negotiation. Support for complex multi-attribute negotiations is a
critical success factor Critical success factor (CSF) is a management term for an element that is necessary for an organization or project to achieve its mission. To achieve their goals they need to be aware of each key success factor (KSF) and the variations between the ...
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
auction An auction is usually a process of buying and selling goods or services by offering them up for bids, taking bids, and then selling the item to the highest bidder or buying the item from the lowest bidder. Some exceptions to this definition ex ...
s 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 Information technology (IT) is the use of computers to create, process, store, retrieve, and exchange all kinds of Data (computing), data . and information. IT forms part of information and communications technology (ICT). An information te ...
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 agent An autonomous agent is an intelligent agent operating on a user's behalf but without any interference of that user. An intelligent agent, however appears according to an IBM white paper as: Intelligent agents are software entities that carry out ...
s. 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 system Alternative trading system (ATS) is a US and Canadian regulatory term for a non-exchange trading venue that matches buyers and sellers to find counterparties for transactions. Alternative trading systems are typically regulated as broker-dealers r ...
s (ATS). As an ATS, ECNs exclude broker-dealers' internal
crossing network 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 displayed market, such as an electronic communication network (ECN), whi ...
s – 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. 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". 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". Professor Terrence Hendershott argues that today "ECN's capture 40% of the volume in NASDAQ securities", and are considerably changing the securities trading market. ECNs' transactions can be completed without broker-dealers. 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 don't 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 29.5 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 The New York Stock Exchange (NYSE, nicknamed "The Big Board") is an American stock exchange in the Financial District of Lower Manhattan in New York City. It is by far the world's largest stock exchange by market capitalization of its liste ...
, 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 Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity, the ease with which an asset can be sold * Accounting liquidity, the ability to meet cash obligations when due * Liq ...
and more availability in the marketplace.
Bank A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets. Because ...
s also reduce their costs as there is less manual effort involved in using an ECN for trading.


See also

*
Extended hours trading Extended-hours trading (or electronic trading hours, ETH) is stock trading that happens either before or after the trading day of a stock exchange, i.e., pre-market trading or after-hours trading. After-hours trading is the name for buying and ...
* NASDAQ *
NYSE Arca NYSE Arca, previously known as ArcaEx, an abbreviation of Archipelago Exchange, is an exchange on which both stocks and options are traded. It was owned by Intercontinental Exchange. It merged with the New York Stock Exchange in 2006 and now op ...
*
Inet Inet was an electronic trading platform based on a system developed by Instinet in the 1970s that merged with Island ECN in 2002 and was subsequently acquired by NASDAQ in 2005. Inet, like other electronic communication networks, was an order-pai ...
*
Island ECN 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. Hist ...
* ECNmarkets


References


Bibliography

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External links


Special Study: Electronic Communication Networks and After-Hours Trading

ECNs/Alternative Trading Systems
{{DEFAULTSORT:Electronic Communication Network Stock market