There are a lot of decisions you must make before you can place a trade on the stock market.
You have to know what you want to buy (or sell) and how much. Do you want to place a market order and accept the next available price, or would you rather set a limit price you’re not willing to go above (or below)? Then there’s the question of where you place that trade.
For most investors, the where — or rather, through whom — question is easy to answer: You place the trade wherever your money is held. But you may want to pay attention to the finer details of what your chosen location implies, such as if your order will be routed through an electronic communication network, or ECN. Keep these points in mind:
— What is an ECN?
— What is an ECN broker?
— The pros and cons of ECNs.
— Should you use an ECN broker?
What Is an ECN?
An ECN is “simply an electronic matching engine that matches market buy and sell orders,” says Dan Raju, CEO of Tradier. When a buyer enters an order for 10 shares of Apple (ticker: AAPL) stock into an ECN, the system pairs that request with a seller (or multiple sellers) who are offering shares of Apple. If there are no sellers to fill the buyer’s request, the buy order is left as an open quote in the electronic order book.
ECNs allow traders to bypass third parties, such as brokers, and trade directly with each other, says Jason Fink, professor of finance at James Madison University. “This differs from the traditional system in which ‘market makers’ trade directly with customers, taking the opposite side of trades and earning their profits from the bid-ask spread.” In this traditional system, instead of buying 10 shares of Apple off someone selling 10 shares of Apple, you’d buy 10 shares from Apple’s market maker.
Since ECNs automatically match buyers and sellers, they also make it easier to enter and exit positions in the financial markets; you don’t have to wait for your broker to do the legwork of finding a counterparty to your trade.
“ECN transactions are still subject to securities regulations and the laws of the jurisdictions where they occur,” says Brian Martucci, personal finance expert at the Money Crashers website.
What Is an ECN Broker?
An ECN broker is a broker or firm that uses ECNs to execute client trades. ECN brokers pass order flow directly to the ECN, bypassing traditional market makers, Fink says.
In this sense, an ECN broker is a type of middleman, but one who uses an ECN to provide access to other participants in the market, Raju says. “Since ECN brokers aggregate price quotations from multiple destinations, they can provide clients with better bid-ask spreads.”
Smaller bid-ask spreads, or the difference between how much people are willing to sell Apple shares for and how much others are willing to buy them for, translate into lower trading costs and better liquidity for investors, making this a key advantage of ECNs.
Pros and Cons of an ECN
ECNs have several potential advantages for individual traders. First, is through tighter bid-ask spreads, which translate to lower trading costs. ECNs are also faster and more private than third-party transactions, Martucci says.
“Further, traders arguably face a more transparent market when dealing with ECNs, relative to the traditional market maker model,” Fink says. “Since market makers are often directly taking the other side of a given trade, large or repeat trades by a customer can cause the market maker to reassess his or her position and potentially increase the bid-ask spread as a method of profit protection.” Anonymity is also easier to maintain when trading via an ECN than a live human being.
Another potential benefit of ECNs is that they’re open when stock exchanges are closed, giving investors additional trading hours. “This provides a chance to react to new information that arrives outside of hours when exchanges are open,” Fink says. Just beware that “market quality deteriorates rapidly after exchanges close, meaning it is more expensive to trade at these times.”
There are some drawbacks to using an ECN, however. “One of the potential disadvantages of ECN trading is market fragmentation,” Fink says. “Because ECNs match buyers and sellers within their systems, there is the risk of insular trading,” which can cause the prices on an ECN to deviate from those in the broader market. This is usually resolved by arbitrage trading, when traders simultaneously buy and sell the same security in two different markets — in this case the ECN and broader market — to take advantage of the price disparity.
ECNs have historically had relatively high minimum account values and trade sizes, Fink adds, which can prevent individual investors from using them. The recent advent of mini-ECN brokers, part of the broader trend toward lower-cost trading for retail investors, has largely mitigated that, though, he says.
“ECN brokers are experts at using ECN systems that aren’t particularly user-friendly,” he says. “They also make it easier for smaller, lower-volume investors to take advantage of ECNs without paying access fees or commissions.” But ECNs don’t come without cost.
ECNs do take commissions, so they may not be suitable for higher-volume investors seeking the absolute lowest cost, Martucci says. “In a world where free stock trading across international lines is increasingly common, ECNs may not be cost-effective.”
Should You Use an ECN Broker?
Given the pros and cons of ECNs, what’s an investor to use: an ECN or traditional market maker? Generally speaking, “ECN brokers are considered a better alternative to traditional desk brokers because they provide a more transparent match between buyers and sellers,” Raju says.
The main caveat is for traders who always use the same ECN, Fink says. If you always route your trades through the same ECN, you might want to keep an eye on market fragmentation, which may cause the ECN’s prices to deviate from those offered in the broader market.
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