ECN VS Market Maker
Most Forex brokers can be divided into two types: brokers that use an ECN system and brokers that are market makers. Some brokers operate both ways, depending on the account. Before choosing a Forex broker it’s important to understand how each of these operates and the advantages and disadvantages offered by each one.
1: Electronic communication network
An electronic communication network (ECN) is a type of computerized forum or network that facilitates the trading of financial products outside traditional stock exchanges. An ECN is generally an electronic system that widely disseminates orders entered by market makers to third parties and permits the orders to be executed against in whole or in part. The primary products that are traded on ECNs are stocks and currencies. ECNs are generally passive computer-driven networks that internally match limit orders and charge a very small per share transaction fee (often a fraction of a cent per share). The first ECN, Instinet, was created in 1969. ECNs increase competition among trading firms by lowering transaction costs, giving clients full access to their order books, and offering order matching outside of traditional exchange hours. ECNs are sometimes also referred to as alternative trading systems or alternative trading networks.
Function
To trade with an ECN, one must be a subscriber or have an account with a broker that provides direct access trading. ECN subscribers can enter orders into the ECN via a custom computer terminal or network protocols. The ECN will then match contra-side orders (i.e. a sell-order is “contra-side” to a buy-order with the same price and share count) for execution. The ECN will post unmatched orders on the system for other subscribers to view. Generally, the buyer and seller are anonymous, with the trade execution reports listing the ECN as the party.
Some ECN brokers may offer additional features to subscribers such as negotiation, reserve size, and pegging, and may have access to the entire ECN book (as opposed to the “top of the book”) that real-time market data regarding depth of trading interest.
ECNs are generally facilitated by electronic negotiation, a type of communication between agents that allows cooperative and competitive sharing of information to determine a proper price.
Negotiation types
The most common paradigm is the electronic auction type. As of 2005, most e-business negotiation systems can only support price negotiations. Traditional negotiations typically include discussion of other attributes of a deal, such as delivery terms or payment conditions. This one-dimensional approach is one of the reasons why electronic markets struggle for acceptance. Multiattributive and combinatorial auction mechanisms are emerging to allow further types of negotiation.
Support for complex multi-attribute negotiations is a critical success factor for the next generation of electronic markets and, more generally, for all types of electronic exchanges. This is what the second type of Electronic negotiation, namely Negotiation Support, addresses. While auctions are essentially mechanisms, bargaining is often the only choice in complex cases or those cases where no choice of partners is given. Bargaining is a hard, error-prone, ambiguous task often performed under time pressure. Information technology has some potential to facilitate negotiation processes which is analyzed in research projects/prototypes such as INSPIRE, Negoisst or WebNS.
The third type of negotiation is automated argumentation, where agents exchange not only values, but also arguments for their offers/counter-offers. This requires agents to be able to reason about the mental states of other market participants.
Technologies
One research area that has paid particular attention to modeling automated negotiations is that of autonomous agents. If negotiations occur frequently, possibly on a minute per minute basis in order to schedule network capacity, or negotiation topics can be clearly defined it may be desirable to automate this coordination.
Automated negotiation is a key form of interaction in complex systems composed of autonomous agents. Negotiation is a process of making offers and counteroffers, with the aim of finding an acceptable agreement. During negotiation, each offer is based on its own utility and expectation of what other . This means that a multi criteria decision making is need to be taken for each offer.
In the stock market
For stock trading, ECNs exist as a class of SEC-permitted alternative trading systems (ATS). As an ATS, ECNs exclude broker-dealers’ internal crossing networks – i.e., systems that match orders in private using prices from a public exchange. ECNs, as alternative trading systems, have increased competition with institutional trading systems. Alternative trading systems have been found to have lower execution costs, however as new ECNs emerge, some of this cost reduction has dissipated. Simultaneously, the growth of ECNs has been found to disrupt institutional trading. An analysis of impact of ECNs on NASDAQ found “tighter spreads, greater depths, and less concentrated markets”. ECNs provide historical orders and price data to subscribers. As a result, ECNs compete through their ability to attract “more informed orders” during “periods of high volume and return volatility”. Today “ECN’s capture 40% of the volume in NASDAQ securities,” and are considerably changing the securities trading market (Hendershott).
ECNs have influenced the stock market by eliminating dealer functions in order-matching. With the automation of orders on mass scale, the role of intermediary traders has been reconfigured. While the ECNs don’t execute decision-making algorithms to the extent of algorithmic trading, nevertheless they have impacted the role of human traders in financial exchange.
Fee structure
ECN’s fee structure can be grouped in two basic structures: a classic structure and a credit (or rebate) structure. Both fee structures offer advantages of their own. The classic structure tends to attract liquidity removers while the credit structure appeals to liquidity providers. However, since both removers and providers of liquidity are necessary to create a market, ECNs must choose their fee structures carefully.
In a credit structure ECNs make a profit from paying liquidity providers a credit while charging a debit to liquidity removers. Credits range from $0.002 to $0.00295 per share for liquidity providers, and debits from $0.0025 to $0.003 per share for liquidity removers. The fee can be determined by monthly volume provided and removed, or by a fixed structure, depending on the ECN. This structure is common on the NASDAQ market. NASDAQ Price List. Traders commonly quote the fees in millicents or mils (e.g. $0.00295 is 29.5 mils).
In a classic structure, the ECN will charge a small fee to all market participants using their network, both liquidity providers and removers. They also can attract volume to their networks by giving lower prices to large liquidity providers. Fees for ECNs that operate under a classic structure range from $0 to $0.0015, or even higher depending on each ECN. This fee structure is more common in the NYSE, however recently some ECNs have moved their NYSE operations into a credit structure.
Currency trading
The first ECN for internet currency trading was New-York based Matchbook FX formed in 1999. Back then, all the prices were created & supplied by Matchbook FX’s traders/users, including banks, within its ECN network. This was quite unique at the time, as it empowered buy-side FX market participants, historically always “price takers”, to finally be price makers as well. Today, FX ECNs like OctaFX, Currenex, DMALINK, Bloomberg Tradebook (an affiliate of Bloomberg L.P.), Hotspot FX, 360T, Integral, FXall & BAXTER Financial Services Ltd with Currency Dealing provide access to an electronic trading network, supplied with streaming quotes from the top tier banks in the world. Their matching engines perform limit checks and match orders, usually in less than 100 milliseconds per order. The matching is quote driven and these are the prices that match against all orders. Spreads are discretionary but in general multibank competition creates 1-2 pip spreads on USD Majors and Euro Crosses. The order book is not a routing system that sends orders to individual market makers. It is a live exchange type book working against the best bid/offer of all quotes. By trading through an ECN, a currency trader generally benefits from greater price transparency, faster processing, increased liquidity and more availability in the marketplace. Banks also reduce their costs as there is less manual effort involved in using an ECN for trading.
History
The term ECN was used by the SEC to define, “any electronic system that widely disseminates to third parties orders entered therein by an exchange market maker or OTC market maker, and permits such orders to be executed against in whole or in part,”. The first ECN, the Instinet, was released in 1967 and provided an early application of the advances in computing. The spread of ECNs was encouraged through changes in regulatory law set forth by the SEC, and in 1975 the SEC adopted the Securities Acts Amendments of 1975, encouraging the “linking of all markets for qualified securities through communication and data processing facilities”.
ECNs have complicated stock exchanges through their interaction with NASDAQ. One of the key developments in the history of ECNs was the NASDAQ over-the-counter quotation system. NASDAQ was created following a 1969 American Stock Exchange study which estimated that errors in the processing of handwritten securities orders cost brokerage firms approximately $100 million per year. The NASDAQ system automated such order processing and provided brokers with the latest competitive price quotes via a computer terminal. In March 1994, a study by two economists, William Christie and Paul Schultz, noted that NASDAQ bid–ask spreads were larger than was statistically likely, indicating “We are unable to envision any scenario in which 40 to 60 dealers who are competing for order flow would simultaneously and consistently avoid using odd-eighth quotes without an implicit agreement to post quotes only on the even price fractions. However, our data do not provide direct evidence of tacit collusion among NASDAQ market makers”.
These results led to an antitrust lawsuit being filed against NASDAQ. As part of NASDAQ’s settlement of the antitrust charges, NASDAQ adopted new order handling rules that integrated ECNs into the NASDAQ system. Shortly after this settlement, the SEC adopted Regulation ATS, which permitted ECNs the option of registering as stock exchanges or else being regulated under a separate set of standards for ECNs.
At that time major ECNs that became active were Instinet and Island (part of Instinet was spun off, merged with Island into Inet, and acquired by NASDAQ),Archipelago Exchange (which was acquired by the NYSE) and Brut (now acquired by NASDAQ).
ECNs enjoyed a resurgence after the adoption of SEC Regulation NMS, which required “trade through” protection of orders in the market, regardless of where those orders are placed.
In the past, many ECNs were “closed book”—i.e., allowing participants to interact only with other participants in that network. However, increasingly ECNs have adopted an “open book” format, addressing the potential fragmented liquidity by integrating orders with those of other ECNs or market makers, thus increasing the overall pool of orders.
2: Straight-through processing
Straight-through processing (STP) enables the entire trade process for capital market and payment transactions to be conducted electronically without the need for re-keying or manual intervention, subject to legal and regulatory restrictions and was invented in the early 90s by James Karat in London to describe automated processing in the equity markets; however, it was used around the same time by SWIFT, the banking cooperative, to describe automated processing in the payments arena.
While working with the London Stock Exchange (LSE) the Sequal project, and LGT A/M, Mr. Karat cites the reason for developing the system as simple. The process before STP was very antiquated: sales traders would have to fill in a deal ticket, blue for buy and red for sell. The order was invariably scribbled and mostly unreadable. Upon receiving the order, the trader would execute on the market a usually incorrect investment. The runner picking up the ticket—in this case, Mr. Karat—would input the order into the system to send out a contract note. For example, if the client wished to purchase 100,000 shares, but the trader only executed 10,000, the runner would send out the contract for 1,000. In those days, there was a T10 settlement so any errors were “fixable”. However, with the new introduction of T5, the settlement arena changed, and STP was born. Mr. Karat realised that to reduce the exposure of risk, failed settlement, there could only be one golden source and that the onus was on the sales trader to be correct as he/she had the power to correct any discrepancies with the client directly.
The concept has also been transferred into other sectors including energy (oil, gas) trading and banking, and financial planning.
Currently, the entire trade lifecycle, from initiation to settlement, is a complex labyrinth of manual processes that take several days. Such processing for equities transactions is commonly referred to as T+3 processing, as it usually takes three business days from the “trade” being executed to the trade being settled. Industry practitioners, particularly in the US, viewed STP as meaning at least ‘same-day’ settlement or faster, ideally minutes or even seconds. The goal was to miniseries settlement risk for the execution of a trade and its settlement and clearing to occur simultaneously. However, for this to be achieved, multiple market participants must realize high levels of STP. In particular, transaction data would need to be made available on a just-in-time basis, which is a considerably harder goal to achieve for the financial services community than the application of STP alone. After all, STP itself is merely an efficient use of computers for transaction processing.
Historically, STP solutions were needed to help financial market firms move to one-day trade settlement of equity transactions, as well as to meet the global demand resulting from the explosive growth of online trading. Now the concepts of STP are applied to reduce systemic and operational risk and to improve certainty of settlement and minimize operational costs.
When fully realized, STP provides asset managers, brokers and dealers, custodians, banks and other financial services players with tremendous benefits, including greatly shortened processing cycles, reduced settlement risk, and lower operating costs. Some industry analysts believe that STP is not an achievable goal in the sense that firms are unlikely to find the cost/benefit to reach 100% automation. Instead, they promote the idea of improving levels of internal STP within a firm while encouraging groups of firms to work together to improve the quality of the automation of transaction information between themselves, either bilaterally or as a community of users (external STP). Other analysts, however, believe that STP will be achieved with the emergence of business process interoperability. As an aside, an enabler of STP is Straight-Through Quality, but this should not be considered a complete solution to STP, as it is just a tool in helping to achieve an STP implementation.
Market Maker
With a market maker it’s a whole different story. A market maker, as the name implies, makes his own market. The buy and sell quotes presented in the market maker platform are determined by the broker. Of course, the quotes you see in a market maker platform change according to the movement of the market as the broker tries to follow events in the world markets.
Who are you trading with?
When you are dealing with a market maker, you are actually trading against your broker. When you open a long position, the broker gets the opposite position. The broker then gets to decide whether to keep the position or to hedge it by opening an opposite position with another liquidity provider.
Using an ECN broker means that you trade against other traders, and it will not matter to your broker what sort of position you’ve opened. The quotes you’ll see will be orders transmitted to the ECN system by other traders or firms.
Spreads
Since the market maker broker controls the quotes, he will usually offer the traders a fixed spread that already includes a commission in it. This spread will be a bit bigger than the spread of an ECN broker, but the additional spread allows the market maker to maintain a given spread on offers even as the market itself is shifting.
On the other hand, an ECN broker will give his traders the best spreads possible. Thanks to the high liquidity provided by the ECN system, those spreads are pretty small. An ECN broker will usually display the spreads as he gets them and will then charge a commission on each trade. Under conditions of high volatility the ECN’s spread will widen as a result of low supply and demand.
To conclude, each type of broker has its own advantages and disadvantages; the right one for you will be the one that enables you to apply your own strategy successfully in the easiest possible way.
FX BUSINESS 