An electronic communication network (ECN) is a computer system that brings together buyers and sellers of a financial instrument and matches their orders automatically, without a human intermediary and outside a traditional stock exchange. Participants enter orders with a price and quantity, the system displays them, and an order to buy is executed against an order to sell when their prices meet.
The term arose in the US equity market, where ECNs appeared as competitors to the exchanges and dealer markets in the 1990s. In US regulation an ECN is a type of alternative trading system that displays its orders publicly. The label is also used in the foreign exchange market, both for the platforms on which banks trade with each other and, more loosely, for a style of retail brokerage.
How an ECN works
An ECN runs a central limit order book. Subscribers, who are brokers, market makers and institutional investors, send a limit order to the system. If a matching order is already present, the two are executed at once by the matching engine. If not, the order rests in the book where others can see it and trade against it. Orders are ranked by price and then by time of arrival.
Three features distinguished early ECNs from the dealer markets of the time. Participants traded directly with one another, not through a dealer who quoted a price and took the other side. Trading was anonymous, with only the price and size shown. And the systems operated before and after regular exchange hours, which gave rise to extended-hours trading.
History
The first system of this kind was Instinet, which began operating in 1969 to let institutions trade blocks of shares with each other. ECNs became central to the market after 1997, when the Securities and Exchange Commission introduced its Order Handling Rules. The rules required market makers to display customer limit orders and to make public the better prices they had been quoting privately on ECNs. This brought ECN quotes into the main quotation system of the Nasdaq market. In 1998 the SEC adopted Regulation ATS, which gave such systems a formal status without requiring them to register as exchanges.
A wave of new ECNs followed, including Island, Archipelago and Brut. They won a large share of trading in Nasdaq-listed shares by offering speed, low cost and open access. The move to pricing shares in cents in 2001 narrowed spreads further and favored automated matching. In the mid-2000s the leading ECNs were absorbed by the exchanges or became exchanges themselves: Archipelago merged with the New York Stock Exchange, Nasdaq acquired the combined Instinet and Island platform, and BATS, founded in 2005 as an ECN, later registered as an exchange.
Fees and the maker-taker model
ECNs earn income from transaction fees. Many adopted a pricing scheme, first used by Island, that pays a small rebate to the participant whose resting order supplied liquidity and charges a slightly larger fee to the participant who took it. The scheme is known as maker-taker pricing, after the roles of market makers and takers. It encouraged firms to post orders, which deepened the book and narrowed the bid-ask spread. It was later adopted by most US stock exchanges and remains debated, since rebates can influence where brokers send client orders.
ECNs in foreign exchange
In the foreign exchange market, electronic matching platforms such as EBS and Reuters Matching took over much of the trading between banks from the 1990s. Later platforms opened similar order books to hedge funds, corporations and smaller banks, with liquidity streamed by many dealers at once.
Retail foreign exchange brokers use the term ECN to describe an account in which client orders are passed to a pool of outside liquidity providers at variable spreads plus a commission, as opposed to a dealing-desk model in which the broker itself is the counterparty and sets the price. The label is a marketing term in this setting and is not defined by regulation, so the actual handling of orders varies from one broker to another.
Effects on markets
ECNs changed the structure of equity trading. They broke the hold of dealers and floor specialists on order flow, cut costs for investors, and showed that a fully automated order book could handle large volumes. They also made possible the growth of algorithmic trading, which depends on fast, direct, rule-based access to a book, and of direct market access for institutions.
The same competition spread trading across many venues. A share that once traded in one place can now be bought on a dozen exchanges and many off-exchange systems, a condition called liquidity fragmentation. Brokers rely on order routing technology to find the best price among them. An ECN differs from dark pools, which are also alternative trading systems but do not display their orders. In Europe the nearest equivalent category is the multilateral trading facility.