What it means
In the past, a trade usually went through a broker and a market maker, a firm that quotes prices at which it will buy and sell. An ECN changes this by acting as a digital meeting place.
Buy and sell orders from banks, brokers and traders are entered into the system, and when a buy order and a sell order match in price, the trade is executed automatically. One key feature is transparency.
Many ECNs display an order book, which shows the prices and sizes of orders waiting to be filled. That gives participants a clearer view of supply and demand than they might get from a single dealer's quote.
ECNs gained importance as trading moved to computers. They allowed trading outside normal exchange hours and let institutions and active traders deal directly with each other.
Over time, many ECNs were absorbed by larger exchanges or evolved into other kinds of trading venues, but the idea of electronic order matching is now standard. For businesses and investors, the benefits are speed, lower transaction costs and often narrower gaps between buying and selling prices, known as spreads.
The cost is that ECNs usually charge a small fee per trade or per share traded. Those fees can be a flat commission or a rebate scheme in which those who add orders to the book pay less than those who take them.
The term also appears in foreign exchange trading, where ECN is used to describe brokers that route client orders to a network of banks and other participants. In every case the common thread is direct electronic matching in place of a single dealer setting the price.
Regulation matters. In many countries, ECNs are overseen by securities regulators and must meet standards on fair access, record keeping and reporting.
Anyone trading through one should check the regulatory status of the venue and of their broker.
In practice
Real-world examples.
Example
An asset manager needs to sell 50,000 shares of a mid-sized company without moving the price. It enters orders on an ECN, where they are matched with buyers directly and the manager avoids paying a dealer's spread. The order is split into smaller pieces so that it does not move the market.
Example
A day trader sees on an order book that many buyers are waiting just below the current price. The trader places a sell order and it is filled within a second at the best available price. The trader reviews the fill report afterwards to confirm the price was fair.
Example
A small broker offers extended-hours trading to its clients by routing orders to an ECN. Clients can respond to earnings news released after the market closes. The broker explains in its terms that prices and liquidity can be thinner at those times.
Case study
Seen in the real world.
This is a fictional story. Birchwood Capital, an invented investment firm, used to place large orders through a single dealer. The dealer quoted a spread of 10 cents on a share priced at $50, and the firm suspected that it was paying more than necessary.
The head trader began routing some orders to an electronic communication network. On the network, the best bid and offer were only 2 cents apart, and the firm paid a small fee per share to the network.
Over a year, the firm saved an estimated $140,000 in trading costs on its larger orders. The head trader noted that the network was less useful for very large trades, where she still preferred to work with a dealer, so the firm kept using both. In both cases, the head trader reviews costs each quarter and adjusts the split between the two routes. The numbers in this story are illustrative.
Watch out
Common mistakes.
- Assuming an ECN is a broker. It is a trading system that matches orders, whereas a broker is a firm that sends orders on behalf of clients.
- Believing electronic trading is free. ECNs charge fees, and the total cost depends on order size and the pricing scheme.
- Assuming every order will be filled. If no matching order exists at your price, the order stays in the book or goes unfilled.
Questions
People also ask.
Who uses ECNs?
Institutional investors, brokers, market makers and active retail traders all use them to find the best price quickly. Each group values something different, such as low cost, anonymity or speed.
How is an ECN different from an exchange?
An ECN is a private electronic network that matches orders, while an exchange is a regulated venue with listing rules, though the line between them has blurred. In many markets, ECNs are now registered as alternative trading systems.
Does an ECN set the price?
No. Prices come from the orders participants enter, and the network only matches them. The network earns its income from fees, not from the price movement. Some networks also pay small rebates to participants who add liquidity.
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