FXCE: Blog | What is ECN? How Does It Work?

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What is ECN? How Does It Work?

Marketing

6 min read

21/08/2023

When participating in the Forex market, the biggest concern of traders is the liquidity of the market, or how the market matches Trader's orders. One of them that solves your questions is ECN, have you heard of ECN or ECN Broker?

Let's learn about ECN, one of the components that is a very important role in creating the Forex market.

What is ECN?

ECN (Electronic Communication Network) is a computer system that automatically matches buy and sell orders in the market. ECN trading is especially useful when investors in different geographies (OTC) want to complete transactions securely without using a third party.

Because ECN has an open structure, it allows developers and related units to execute their orders quickly and optimally. Banks, investment funds and investors from retail to institutional level are all components that have a great influence on the market. They create an abundance of liquidity in the Forex market.

Understanding ECN

To be precise, ECN is a computer-based system that displays the best bids available and simultaneously requests quotes from multiple market participants. After that, the trading orders will be matched automatically.

As a result, they not only facilitate major exchanges during business hours, but are also used for after-hours and Forex trading. ECN allows automatic trading, passive order matching and fast order matching.

In essence of the ECN , it creates a mechanism of exchanges that do not hold orders aka No Dealing Desk. Instead, all orders will be transferred directly to the large market, where investors share the same ECN network. Accordingly, we will have direct interaction with other traders, funds, banks and investment units.

It means that ECN brokers are non-dealing desk brokers, they do not pass on order flow to market makers. Instead, they match participants in a trade electronically and pass the orders to liquidity providers.

How it works

First, the ECN system aggregates all order data (including buyers and sellers) available in the foreign exchange market. This will include all trading parties, liquidity providers, and investors large/small. Then the system will automatically match buy and sell orders at the same price and prioritize execution of these orders.

If the corresponding order information is not found, the system will choose the highest BID price and the lowest ASK price and execute these prices. From there, you can select and place Limit orders as needed.

In addition, even if the liquidity provider offers the best prices in the market, they still require a relatively large minimum trade volume. Therefore, it is often difficult for ordinary investors to meet this requirement and can only trade in small amounts. In addition, certain lines of credit to qualify for trading with liquidity providers.

That's when you need an ECN Forex Broker . They bridge the gap between major liquidity providers or interbanks and retail investors or smaller market traders.

Advantages of using ECN

The main benefit of using ECN is transparency in pricing, as well as in terms of data availability. All ECN brokers have access to the same exact data feed and trade at the exact prices offered.

A certain amount of historical price data is also available and transparent, they are displayed on charts, allowing individuals and organizations to analyze market trends more easily. This helps limit price manipulation because current and past information is available on the chart to everyone.

Additionally, because every trader has access to the same information and data source, no trader has an edge over the others.

Another benefit that traders like the most about an ECN account is that the spreads are quite low and accessible to everyone. Even the Bid/Ask spread seems to be close to zero for pretty much every major forex currency pair.

Disadvantages of using ECN

One of the biggest downsides to using ECN is that you have to pay commissions. Typically, fees and commissions for using an ECN can be higher than for systems outside of the ECN (depending on the case). As a result, commissions based on each trade direction can be expensive and can affect a trader's bottom line.

In terms of leverage, it can be seen as an advantage for some traders, or it can also be seen as an advantage. For ECN , the leverage is not high. Although this is a disadvantage for many traders, it also becomes a big advantage. Because the forex market has many traders who do not like to take risks with high leverage. Typically, ECN accounts will offer leverage levels of 1:100, 1:200, and 1:500.

Another interesting information about ECN

Some of the major ECNs are Instinet, SelectNet, and NYSE Arca. Instinet is the first ECN , established in 1969 and used by retail brokers for inter-institutional transactions. This makes it widely used by market makers for NASDAQ transactions, but can also be used by individuals and small businesses.

SelectNet is again used primarily by market makers, but it does not require immediate order execution and helps investors trade with specific market makers. NYSE Arca evolved between the New York Stock Exchange (NYSE) and Archipelago, an ECN as early as 1996. It facilitates electronic trading of securities on major US exchanges such as the NYSE and NASDAQ.

ECN Broker vs Market Maker

An ECN broker is a financial intermediary that uses electronic communications networks (ECNs) to give clients direct access to other participants in equity and currency markets. Because an ECN broker consolidates price quotations from several market participants, it can generally offer its clients tighter bid/ask spreads than would be otherwise available to them.

An ECN broker only matches trades between other market participants; it cannot trade against the client. ECN spreads are often narrower than those used by conventional brokers, but ECN brokers still charge clients a fixed commission per transaction.

Difference with ECN - Market makers "make" or set both the bid and the ask prices on their systems and display them publicly on their quote screens. They stand prepared to make transactions at these prices with their customers, who range from banks to retail forex traders. In doing this, market makers provide some liquidity to the market.

As counterparties to each forex transaction in terms of pricing, market makers must take the opposite side of your trade. In other words, whenever you sell, they must buy from you, and vice versa.

Summary

ECN - Electronic Communication Network allows brokers and investors in different geographies to trade without the involvement of third parties, providing investors with privacy.

Without market makers and ECNs , it would take longer for buyers and sellers to match. This will reduce liquidity, make it more difficult to enter or exit positions, and increase trading costs and risks.

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