What is ECN in Forex: How Does it Work?

Prior to the 1970s, trade transactions were handled manually with a broker or counterparty. A very limited form of electronic trading existed till the mid-80s. Around this time, an advanced communication system developed by Reuters, also known as Reuters Dealing, was the primary source of electronic forex trading. This was the direct-dealing system, a closed network, real-time chat system, even before the internet era.

The modern form of the electronic system flourished from the early 90s, for the institutional inter-bank market. Buyers and sellers would be matched by these systems, which became the benchmark of currency prices. Although ECN or Electronic Communications Network was on the scene since the late 1960s, currency trading didn’t start until 1999, when MatchbookFX was launched.

Electronic Communication Network (ECN)

Often called alternative trading systems (ATS), ECN is a computerised network or forum that enables trading of stocks and currencies outside traditional exchanges. The system consolidates price quotes from several market participants and offers traders exclusive and tighter bid/ask spreads that they normally wouldn’t have access to. The network matches limit orders internally and charges a very small transaction fee.

ECN forex brokers are non-dealing desk brokers. This means, the orders are not passed on to market makers, but rather directly to high-liquidity providers.

How Does ECN Work?

Orders are entered by subscribers through a custom computer terminal or protocol. ECN matches sell orders with buy orders of the same price for execution. Unmatched orders are posted on the system, which everyone can view. Generally, the ECN is listed as the party, while the buyers and sellers remain anonymous in the trade execution reports. These networks are provided live streaming quotes from top tier banks across the world.

The matching engines or algorithms match orders and perform limit checks, generally in less than 100 milliseconds. Spreads are discretionary, but the competitive environment, enabled by the presence of multiple banks, creates 1-2 pip spreads on all major currency pairs, such as the USD pairs or euro crosses. Consider it as a live exchange that offers the best bid/ask rates from all currency quotes. In case specific order information is unavailable, the system offers prices that reflect the lowest ask and highest bid available in the open market.

Since an ECN broker connects traders with other market participants, it cannot enter into trades against the clients. Retail forex brokers are regulated by stringent laws that prohibit them from a conflict of interest with their clients.

Benefits of Trading Currency on ECN

The biggest advantage of trading with an ECN broker is access to the best prices for trade execution, since these prices are a summary of all the information provided by other traders and institutions. There is no conflict of interest between a broker and a trader, which enables prices to reflect real market conditions.

There is also no incentive to adjust the bid/ask rate by brokers for their own advantage. Trading is anonymous and neutral. This is beneficial for traders who are involved in making large transactions. Prices are fair, so even if slippages occur in volatile market conditions, one can still be assured that these prices are purely driven by supply and demand factors.

Prices on ECN systems are very sensitive to volatility, which makes it an ideal way to trade for scalpers. High liquidity enables fast trade execution. During periods of high activity in the market, the spreads can get very narrow.

All ECN brokers have access to the exact same price feed. Traders can easily connect their expert advisors, trading algorithm models and risk management systems to the live market data feed and price matching engine. The entire trading process remains consistent and reliable, even for back-testing trading models.

Investors have the option to trade outside the normal trading hours. This is beneficial to those who cannot actively trade in normal market times, offering a lot of flexibility.

Commission costs are fixed, as opposed to market makers, who vary the spreads to make profits. Transaction costs are fully disclosed before trade execution, which promotes transparency. Price history is available to a certain extent, and these are accurate. Traders can use them for analysis of market trends.

All in all, ECN provides benefits such as:

• Anonymity
• Global liquidity access (top banks, hedge funds and other big players)
• Live and transparent market data feed (extensive price depth levels)
• Immediate trade execution
• Tighter spreads

Are There Disadvantages in ECN Trading?

Trading is cheaper, but the system is expensive. For a retail trader, the system is often beyond reach, due to its inter-banking nature. Trades are executed in large lots and minimum deposit requirements can be high for some.

Even though the transaction costs are often higher than non-ECN systems, they are fixed and predictable. Slippages still occur, particularly during session overlaps, due to several factors that affect the price ticks. Many traders report that stop-loss calculations can get challenging on ECN platforms. The presence of variable spreads could affect a trader’s bottom-line and profitability.

ECN and Dark Pools – Not the Same

It is easy to see them as being alike, but ECN systems are not like dark pools at all. Although the latter is also an alternative trading system (ATS), ECNs display orders in consolidated quote streams. ECN brokers are required to register with the US SEC in the capacity of broker-dealers, and they are members of the FINRA.

In the UK markets too, ECN providers have to get registered and authorised by the FCA, before they can offer their services to traders.

Reference Links

• https://www.investopedia.com/terms/e/ecn.asp
• https://www.financemagnates.com/forex/brokers/finally-the-brokers-guide-explaining-what-market-maker-stp-and-ecn-brokers-really-are-part-22/
• https://en.wikipedia.org/wiki/Electronic_communication_network
• https://www.sec.gov/fast-answers/answersecnhtm.html