What is an Electronic Communication Network?

An automated computer system that connects buyers and sellers through their orders for the same securities on a listed market, is known as an ECN or "electronic communication network". It is a digital system that takes trading outside of the physical market. Large brokerage firms form partnerships with individual traders so they can trade directly with each other without going through an intermediary. The electronic communication network allows investors to trade from any location, irrespective of the geographies involved. ECN makes trading swift and easy.

How does ECN work?

The ECN is a computerized system that displays the best bids and quotes from multiple market participants. It automatically matches traders - one request with one offer - and thus executes orders. ECN is used on major stock exchanges, foreign currency transactions, or after-hours orders.

ECNs generate revenue by charging a fee on every transaction so one can meet their financial obligations. Its essential purpose is to eliminate third parties, such as a broker, which typically acts as an ECN to create orders and connect traders with other traders.

The technical name for this role is known as the Market Maker for public exchanges or Over-The-Counter (OTC) Trading. Market makers, match traders, and work together to ensure that all orders are partially or fully fulfilled. All orders placed through the ECN are usually restricted. This is partially useful if you want to trade safely outside business hours. Stock prices are very volatile, so after-hours trading offered by ECN adds a layer of security to your position.

Despite its advantages, accessing the ECN is expensive. Investors must pay an access fee and commission on the trade executed through ECN.

Who is ECN for?

Traders use the electronic communication network to trade outside of traditional trading hours. It provides a robust mechanism for those who cannot actively participate during normal market hours. It is also favored by those who prefer flexibility in their trading time range. ECNs also avoid wider spreads that are typically encountered with traditional brokers and have relatively lower fees and commissions. For those concerned about privacy, ECN provides the same level of security as confidentiality when it comes to transactions. It may be used by investors who want anonymity in large-scale transactions.

In addition to ECN, matching systems and call markets are also considered a form of an alternative trading system. The matching system receives the order and directs the activity through the matching engine instance. Here, the price is compared to the current remaining limit orders. If no match is found, the order will be immediately placed in the book as a quote. The call market accepts orders one at a time, and the exchange activity after the order determines the bid and ask prices.

Functions of Electronic Communication Network

In electronic communication networks, buy and sell orders for securities are automatically matched by a computerized system. As the name suggests, transactions are executed electronically. To trade with an ECN, you must be a subscriber or have a broker account that provides direct access to the trade. Investors who do not have time to enter the traditional stock exchange market use ECN. They increase investor flexibility and make them available for longer-term trading.

Unlike physical and traditional markets with business hours, trading on ECNs continues even after trading hours. Bid and ask prices offered by various investors at a particular point in time are displayed on a computerized system. ECN supports the rapid execution of buy and sell orders for securities. There are different types of ECN: one for institutional investors and one for small investors.

Some brokers provide subscribers with additional features such as negotiation, reserve size, and pegging to access the entire ECN book (rather than the "top of the book"), and real-time market data regarding the depth of trading interest. ECN is also considered to be effective in processing small orders.

Examples of Electronic Communication Networks

The first type of electronic communication network (ECN) was created in 1969 and was called ‘Instinet’. Consequently, several other ECNs have been developed, such as SelectNet and NYSE Area.

These ECNs can be used by small traders and institutional investors. Market makers and small brokerage firms also use ECNs to facilitate transactions between investors. NYSE Area was born from the merger of the New York Stock Exchange (NYSE) and the archipelago in the 1990s. This ECN is used for stock trading in the United States. SelectNet, on the other hand, is used by market makers or ECN brokers to facilitate transactions between investors over electronic platforms.

In foreign exchange markets, particular Forex brokers are designated ECN brokers who facilitate currency trades across electronic matching networks.

ECN vs. Market Marker

The term market maker refers to a large number of traders who literally “make a market” for stocks by being able to buy and sell at any time. In contrast to ECNs, market makers benefit from bid spreads, and not through commissions or fees. Like ECNs, it benefits the market by increasing liquidity.

The Market marker sets both bid and ask prices on the system and publishes them on the quote screen. Market makers make profits through spreads which are usually kept lower than what investors can find on ECNs. Without the market maker and ECN, it would take a considerable amount of time for buyers and sellers to coordinate with each other. This reduces liquidity, makes it difficult to get in and out of positions, and increases transaction costs and risks.

What are the Advantages of Electronic Communication Networks?

• ECN provides a mechanism for investors to trade outside of traditional trading hours and not actively participate during normal business hours providing the flexibility of higher availability. It also avoids the wider spreads that are common when using traditional brokers and offers lower commissions overall.
• For those concerned about privacy, ECN can provide some degree of anonymity to those who desire it. This is of particular interest to investors interested in larger transactions.

What are the disadvantages of Electronic Communication Networks?

• One of the biggest drawbacks of using ECNs is the price. Access fees and commissions can be costly and difficult to avoid. Trade-based commissions can be costly and can impact profitability.
• Another drawback of using the ECNs is that the platform is less user-friendly than traditional brokers. Additionally, the lack of built-in charts and data provided by traditional brokers on the interface can be difficult for beginners.

Final word

In summary, ECN is a computerized portal that matches contra-side orders between traders on a particular exchange or market. They make trading efficient by improving inherent speed and flexibility. The only potential drawback of using an ECN is that if you make many transactions every day, you incur large transaction fees and commissions.