Electronic Communications Networks (ECNS) - The Development Of The Ecn Industry

THE DEVELOPMENT OF THE ECN INDUSTRY

The earliest precursor to the modern ECN was Instinet Corp., founded in 1969 by Reuters Group PLC as a venue for institutional investors to trade after regular trading hours. 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 mid-1990s—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 1996, requiring all market makers to publish their orders on NASDAQ. Alternatively, the SEC allowed market makers to publish on an ECN that would subsequently list the order on the NASDAQ Level II quotation system. 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 1990s. 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. One of the biggest ECNs, Island ECN Inc., was majority-owned by the online brokerage Datek Online Holdings Corp., which was deeply entrenched in day trading.

By late 2000, only a dozen or so ECNs were in operation. However, the floodgates were ready to open during the early 2000s, unleashing many new ECNs that sought to grab a piece of the market and carve out a distinct competitive niche. 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. A viable system capable of handling heavy trading volume could be set up for less than $10 million, according to some estimates.