What it means
Brokers fall broadly into two camps. A dealing desk broker takes the other side of your trade and sets its own prices, while an ECN broker passes your order into a network and lets the market decide the price.
The ECN broker's role is to give you access to that network and to execute your orders. Because the prices come from many participants, ECN brokers usually show tighter spreads than dealing desk brokers, sometimes close to zero during busy periods.
In exchange, they charge a commission on each trade. The total cost of trading is therefore the spread plus the commission.
This model is especially popular in foreign exchange trading, where retail investors use ECN brokers for transparent pricing. It suits active traders who place many orders and want to avoid conflicts of interest, because the broker does not profit when the client loses.
The broker's interest is in keeping the client trading. There are downsides.
Commissions can add up for traders with many small trades, minimum deposits are sometimes higher, and spreads can widen sharply during news events when liquidity thins. Orders may also be filled at a different price from the one on screen, which is called slippage.
Anyone considering an ECN broker should check that it is regulated by a recognised authority, that client money is kept in separate accounts, and that the fee schedule is clear. Marketing claims about low costs are best tested by working out the full cost of a typical trade, as in the example below.
It is also worth being careful with labels. Some brokers describe themselves as ECN even though they route only part of their flow to a network, so the claim should be checked rather than assumed.
In practice
Real-world examples.
Example
A part-time trader trades currencies several times a day. She chooses an ECN broker because the tight spread plus a clear commission is cheaper overall than the wider spread of her previous broker. She keeps a spreadsheet of every trade to confirm the saving is real.
Example
A small hedge fund wants transparent execution without a broker trading against its orders. It opens an account with an ECN broker and checks every fill against the order book. Any unexpected fill price is raised with the broker the same day.
Example
A novice investor makes only two trades a year. For such a low volume, the investor finds that an ECN broker's minimum deposit and commission bring little benefit over a simple account. The investor decides that simplicity is worth more than the small saving.
Formula
Calculation
Total cost per trade = Spread cost + Commission
Spread cost = Spread in pips x Pip value x Number of lots
Worked example for a currency trade with an ECN broker. For a standard lot of 100,000 units of EUR/USD, one pip is worth $10.
Spread: 0.1 pips
Number of lots: 2
Commission: $7 per lot, charged on the round trip (opening and closing)
Spread cost = 0.1 x $10 x 2 = $2
Commission = $7 x 2 = $14
Total cost = $2 + $14 = $16
A dealing desk broker quoting a 1.2 pip spread with no commission would cost 1.2 x $10 x 2 = $24 for the same trade, so the ECN broker is cheaper in this example.Case study
Seen in the real world.
This is a fictional story. Larkspur Trading, an invented proprietary trading firm, moved its currency trading from a dealing desk broker to an ECN broker. The firm placed about 400 standard lots a month and was unhappy about widening spreads.
Under the old arrangement, the average spread was 1.2 pips, costing about $12 per lot, so the monthly cost was around $4,800. The ECN broker offered an average spread of 0.2 pips, or $2 per lot, plus a commission of $7 per lot, which came to $9 per lot, or $3,600 per month.
The firm saved about $1,200 per month, or $14,400 a year. It also noticed that spreads widened during major news, so the traders avoided placing large orders at those times. The firm also asked its broker to supply a monthly cost report so it could verify the savings claimed. The story is illustrative and the figures are chosen for simplicity.
Watch out
Common mistakes.
- Judging an ECN broker on the spread alone. The commission must be added to find the true cost of each trade.
- Assuming zero spread always means low cost. Spreads can widen during news, and commissions apply regardless.
- Believing every broker that says it is an ECN broker is one. Check how orders are actually routed and whether the broker is regulated.
Questions
People also ask.
How does an ECN broker make money?
Mainly through commission on each trade, and sometimes a small mark-up on the spread. Some brokers also earn income from account services and financing charges.
Is an ECN broker better than a market maker?
It depends on trading style, as active traders often prefer ECN pricing while occasional traders may favour simpler fee structures.
What is slippage?
It is the difference between the price you expected and the price at which your order was filled, and it can occur in fast markets. Limit orders can reduce slippage, but they may not be filled at all.
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