Electronic Communications Networks (ECNS) - How Ecns Work

HOW ECNS WORK

In order to understand ECNs, one must understand the system they're up against. The chief competition to ECNs came from what are known as market makers on NASDAQ: the investment banks and brokerage houses that stampede to buy and sell stocks so as to fill open orders from clients, providing instant liquidity. While such firms carry a great deal of clout and tend to dominate the exchanges, they typically generate their margins by selling shares at higher prices than what they paid for them.

Meanwhile, ECNs simply create the networks traders use to find each other without relying on the market makers to facilitate transactions. To create a revenue stream, ECNs simply levy a small surcharge—usually no higher than a few cents per share, and often much less—on each trade. 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 2000s 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 2000s. Meanwhile, to hedge their bets some of the major brokerage houses threw their money and support behind ECNs. Merrill Lynch, J.P. Morgan Chase, and Goldman Sachs were a few of the major names with a stake in ECNs.

In March 2000, Island president Matthew Andersen testified before the U.S. Senate Banking Securities Subcommittee, praising ECNs with ushering in "a rapid and sweeping democratization of the markets." Many ECN enthusiasts sounded similar praises, insisting that ECNs brought to the common trader the kinds of benefits larger, institutional investors have always enjoyed.