Electronic Communications Networks (ECNS)

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ELECTRONIC COMMUNICATIONS NETWORKS (ECNS)

Electronic communications networks (ECNs), the headache of major stock exchanges in the late 1990s and early 2000s, are computerized trading systems through which buyers and sellers of stocks and other securities have their orders matched via instant digital transactions. Although electronic trading through ECNs takes a variety of forms, one thing they all have in common is that they undercut the major brokerage houses and New York Stock Exchange (NYSE) specialists, such as Merrill Lynch and Goldman Sachs. By eliminating these middlemen in securities trading, ECNs offer significantly lower transaction costs. Because of their speed and low costs, ECNs were widely used by online brokerages, some institutional investors, and day traders.

ECNs are most conspicuous on the NASDAQ exchange, where they got their start. The NYSE, with its layers of complex rules and regulations regarding the trading of large-capitalization securities, has been much more resistant to encroachment by ECNs. By early 2001, ECNs accounted for a hefty 35 percent of all NASDAQ trading volume, and research firm Cerulli Associates predicted that share would reach 50 percent in 2001. Celent Communications, however, didn't expect ECNs to capture that much of NASDAQ until 2003.

HOW ECNS WORK

In order to understand ECNs, one must understand the system they're up against. The chief competition to ECNs came from what are known as market makers on NASDAQ: the investment banks and brokerage houses that stampede to buy and sell stocks so as to fill open orders from clients, providing instant liquidity. While such firms carry a great deal of clout and tend to dominate the exchanges, they typically generate their margins by selling shares at higher prices than what they paid for them.

Meanwhile, ECNs simply create the networks traders use to find each other without relying on the market makers to facilitate transactions. To create a revenue stream, ECNs simply levy a small surcharge—usually no higher than a few cents per share, and often much less—on each trade. Buyers and sellers connect to ECNs, either personally or through a brokerage, and enter a bid. These orders are then listed anonymously on the ECN's notebook, or order book, while the computer searches the entire system for a match, or a corresponding bid that matches the buyer's or seller's listed price. Once the match is found, the ECN executes the transaction. Since ECNs don't earn money on the spreads between buy and sell orders, as traditional brokerages and investment banks do, they rely on the sheer volume of trading through their networks to generate revenue.

Traditionally, ECNs were open only to other users on the same system, meaning that an order would wait on the ECN's order book until a corresponding bid was placed on the same system. However, in the early 2000s the use of such closed systems was declining in popularity. ECNs like Archipelago began offering open trading systems in which unmatched orders were transferred to and listed on other trading systems. In this way, ECNs can offer the greatest amount of liquidity to investors, allowing them to complete their order as quickly as possible. To boost the level of liquidity, many ECNs began to pool their resources using inter-ECN links and powerful order routing and search engine technology to sift through many ECNs simultaneously, seeking out order matches. Since investors typically place a premium on liquidity, the pressure on ECNs to open their systems was likely to intensify.

In the face of heating competition, differentiation has come to drive competition in the ECN industry. Some, such as Instinet, sought to capture the institutional investment market for electronic trading. Other ECNs, like Island, settled on the day trading market, which, while humbled, was still vibrant in the early 2000s. Meanwhile, to hedge their bets some of the major brokerage houses threw their money and support behind ECNs. Merrill Lynch, J.P. Morgan Chase, and Goldman Sachs were a few of the major names with a stake in ECNs.

In March 2000, Island president Matthew Andersen testified before the U.S. Senate Banking Securities Subcommittee, praising ECNs with ushering in "a rapid and sweeping democratization of the markets." Many ECN enthusiasts sounded similar praises, insisting that ECNs brought to the common trader the kinds of benefits larger, institutional investors have always enjoyed.

THE DEVELOPMENT OF THE ECN INDUSTRY

The earliest precursor to the modern ECN was Instinet Corp., founded in 1969 by Reuters Group PLC as a venue for institutional investors to trade after regular trading hours. Thus, Instinet was more of a private system that catered to established investors, rather than to the more wide-open customer base served by modern ECNs.

On the heels of a NASDAQ trading scandal in the mid-1990s—in which market makers were accused of conspiracy to skim profits by refusing to carry out unprofitable orders and by filling orders at prices that didn't meet buyers' expectations—the Securities and Exchange Commission (SEC) issued new order handling rules in 1996, requiring all market makers to publish their orders on NASDAQ. Alternatively, the SEC allowed market makers to publish on an ECN that would subsequently list the order on the NASDAQ Level II quotation system. As a result of this ruling, the activities of the exclusive electronic trading networks like Instinet were forced into public view, and the modern ECN industry was born.

The emergence of major ECNs coincided, happily enough, with the day-trading phenomena of the late 1990s. This worked out perfectly for ECNs, since day traders typically were nontraditional investors with no solid roots in, or relationships with, the large brokerages. Instead, day traders were looking for quick and cheap ways to place a flurry of orders and reap a quick profit. Thus, the market conditions were ripe for new investment vehicles like ECNs to grab a piece of the action. One of the biggest ECNs, Island ECN Inc., was majority-owned by the online brokerage Datek Online Holdings Corp., which was deeply entrenched in day trading.

By late 2000, only a dozen or so ECNs were in operation. However, the floodgates were ready to open during the early 2000s, unleashing many new ECNs that sought to grab a piece of the market and carve out a distinct competitive niche. At the same time, however, analysts generally agreed that the field could not sustain such a glut of competitors over time, and the industry was expected to ripen for consolidation rather quickly. One factor driving the influx of new ECNs was the relatively low barrier to market entry. A viable system capable of handling heavy trading volume could be set up for less than $10 million, according to some estimates.

DUKING IT OUT WITH THE EXCHANGES

By the turn of the 21st century, ECNs were generating heavy enough trading volume to make the customary exchanges, such as NASDAQ and NYSE, extremely nervous. Indeed, several leading ECNs even filed with the SEC to acquire exchange status themselves, which set off a small war with the traditional exchanges. When ECN giant Archipelago Holdings LLC merged with the Pacific Stock Exchange to create the first ECN-exchange hybrid, it was able to simultaneously function as an exchange and trade stocks through NYSE. Island and NexTrade Holdings Inc. followed a similar path, and as they moved closer to regulatory approval the major exchanges, particularly NASDAQ, took arms in defense. Upon assuming exchange status, ECNs would enjoy direct access to the National Market System linking all stock exchanges, while having their quotations listed alongside those of other exchanges across the nation.

In 2001 NASDAQ attacked Archipelago's ambitions, going so far as to complain to the SEC that such moves were anticompetitive. At first blush, this complaint from a system that trafficked 2 billion shares per day against an ECN that moved 100 million daily shares looked incongruous, but it was in fact indicative of the exchanges' fear of ECNs' potential—particularly that of NASDAQ, which was the most immediately threatened.

The move toward exchange status had a pragmatic component as well. Following the tech market bust in 2000, day trading suffered a tremendous blow. While it hardly disappeared from the scene, a large portion of the natural customer base that ECNs enjoyed on their way to success was no longer a sure bet. Therefore, taking advantage of the benefits of exchange status would help to maintain them during the post-bull market. Exchange status also is the doorway to the extremely lucrative business of packaging and selling market data like stock prices. This is a coveted benefit, particularly since ECNs still suffer a competitive disadvantage when it comes to liquidity.

ECNs were given a break on the NYSE in 2000, courtesy of the SEC. The NYSE's Rule 390 prohibited ECNs from trading NYSE stocks that had been listed since before 1979. This added up to nearly one-third of total NYSE shares and half of the exchange's trading volume, including some of the biggest blue-chip stocks. This rule clearly restricted the range of business ECNs could conduct, and excluded them from some of the most widely demanded stocks on the NYSE. However, by 2000 the SEC strongly pressured the NYSE to repeal Rule 390, creating new opportunities for ECN growth.

One threat to ECNs was the looming possibility of a total overhaul of the NYSE and NASDAQ to create centralized systems that would effectively render ECNs superfluous by incorporating the major ECN functions. NASDAQ received approval in late 2000 to introduce its SuperMontage, a quote aggregation and execution system that will display the three best prices for a given stock and provide a vehicle by which customers' orders can be routed to any venue for completing the transaction. By combining the efficiencies and transparency of ECNs with the vastly greater liquidity of NASDAQ, SuperMontage posed a serious threat to ECNs, which registered their chagrin in the political arena. The ECN lobby caught the ear of House Commerce Committee Chairman Tom Bliley, who sent a letter to the SEC questioning the potentially unfair advantages SuperMontage would afford NASDAQ. Meanwhile, the NYSE began rolling out its own ECN, called Network NYSE.

ECNs also led the way in moving trading systems away from the antiquated practice of listing stock prices with fractions. Island ECN began the decimalization of its stock listings in July 2000, prompting other trading systems to follow suit. In this way, listed stock prices appeared in the form of dollars and cents. This practice also was competitively advantageous to ECNs in their struggle against the market makers. Market makers, earning margins by the spread between the buy and sell price, could use the fraction system to artificially pad those spreads. While this effectively adds up to less than seven cents a share—or one-sixteenth of a dollar, the smallest trading "tick" available in the fraction system—those pennies add up to astronomical sums over several million trades. And given that ECNs survive by the few pennies or less per share they charge for trades through their systems, switching to the more accurate decimal systems and pressuring the exchanges to do likewise closes off a major competitive rift between ECNs and market makers.

In the early 2000s, analysts were mixed in their predictions for the future of ECNs. Some felt they would drive securities trading while others insisted they would be phased out once the major exchanges co-opted their advantages. However, all agree that ECNs have been a major force in driving innovation in securities trading, and that the future of the markets will reflect the ECN influence.