If you're a direct access trader, does it matter which electronic communication network, or ECN, you use? The answer is yes.
Some provide more liquidity. Others offer high-speed fast order routing. Still others route both
These critical differences were laid out for me this week by Dana Stiffler, an analyst with the Boston-based financial-research firm
Meridien Research. Stiffler has studied ECNs extensively and maintains that some offer options that others don't. "It's the value-added services that are important," she says.
A little background: ECNs are computer networks that bypass Nasdaq's market makers and directly link buyers with sellers. To access an ECN, you need to sign on with a broker that's partnered up with at least one of them. That generally means a "direct-access" broker, so named because the brokers enable you to access these computer networks directly. (See how
readers viewed their direct-access brokers in this recent
Active traders love ECNs because they can send out
limit orders that lie within the
ask spread market makers maintain. For example, say the spread on
is a $93.25 bid (offer to buy) and a $93.38 ask (offer to sell). If you spot an offer on the ECN to buy shares at $93.31, you can hit that price, and if you're fast on the draw the trade will go through immediately. By contrast, if you simply entered a limit order to sell at $93.31 through your broker's market makers, the market makers might sit on the order for precious seconds, and during that time the price could change.
Using the ECNs, traders scrape off an extra 13 cents or 6 cents (1/8 or 1/16 of a point, respectively) when they buy or sell stocks. Many traders live and die by such fractional gains.
Individual traders aren't the only ones who use ECNs. Many institutions route their orders through them as well. ECNs as a whole account for 34% of the volume on Nasdaq, according to Stiffler's research.
Follow the Money
At last count there were no less than 11 ECNs:
To make things even more complicated, each of these ECNs handles orders in a slightly different manner. And all charge different commissions, which tend to be a fraction of a penny or more per share. So how do you choose?
Four ECNs -- Instinet, Island, Archipelago and RediBook -- account for nearly 85% of the volume handled by all ECNs, Stiffler says. "For an active trader you don't need to pay attention to those other ones." In other words, liquidity matters. If there aren't a lot of traders to match your trades, you have less of a chance of getting a decent execution.
Here's a closer look at each of the top four ECNs.
Launched way back in 1969 and owned by
, Instinet handles roughly 40% of all ECN volume. So far only institutional traders can access Instinet during regular market hours. Individual traders have been excluded (though some brokers do offer after-hours access). But that is expected to change in the next couple of months when Instinet.com launches as a retail brokerage. The brokerage's software is undergoing final testing. Instinet.com will reportedly let you open an account for $2,000, and its commission rates are expected to be competitive with other online brokers.
Besides the fact that Instinet is a seething cauldron of liquidity, there are other reasons traders might consider using it. Instinet offers links to some 40 global stock markets. That means you can buy shares of foreign stocks directly (instead of purchasing them via American Depository Receipts (ADRs) sold on U.S. exchanges). Also, if you're a chronic insomniac, you'll be able to log onto Instinet around the clock and find plenty of action.
Island ranks second among ECNs, handling roughly 20% of ECN volume. It's seeking to expand by courting institutional traders and providing links to foreign exchanges. But for now, Island functions as a kind of portal for legions of individual active traders. Some traders I know spend their day exclusively on Island, frenetically buying and selling volatile technology shares.
Island's order book closely resembles the Nasdaq Level II quote system. It lists buy and sell offers side by side, starting with the best price and moving down from there. Unlike Nasdaq Level II, which costs $50 a month, the Island book is free. Another advantage to Island is access. Virtually every direct-access broker links to Island, as does
, Island's affiliate brokerage. Datek provides a simpler order interface and its commissions are about one-third less than what direct-access brokers typically charge.
ECN Archipelago recently teamed up with the San Francisco-based
Pacific Exchange, a regional stock and option exchange. Thanks to the partnership, the
Securities and Exchange Commission
now classifies Archipelago itself as a stock exchange, the same designation it gives to the NYSE. Other ECNs are classified as broker dealers, which is the classification the SEC gives to online brokers.
The distinction might seem like a legal fine point, except for one important fact: Because it's an exchange, Archipelago can trade listed stocks over a network called the National Market System. (Archipelago users can also trade Nasdaq stocks.) Listed stocks mostly trade on the NYSE; almost none are routed through ECNs. By trading listed stocks via Archipelago, you can bypass the NYSE specialists. And that presumably gives you a better chance of getting inside the bid/ask spread.
Besides offering access to listed securities, Archipelago also links to other ECNs using a technology called SmartBook. When you send an order to Archipelago using SmartBook, the software first looks for a match within its own system. If none appears, the order is automatically routed to another ECN or exchange where a buyer with a matching price may await.
Those familiar with direct access brokers might say that SmartBook is exactly the same as the smart-order routing feature brokers like
offer. But there is a small yet potentially important difference. As Stiffler explains it, the smart-order routing software used by many direct-access brokers resides on your own desktop PC. If that software spots a trading opportunity, the order is sent from your desktop to your broker and then onto the ECN in question. If your Internet connection slows down for some reason, the offer may no longer exist by the time your order gets transmitted.
With SmartBook, your trade resides on the network server while it searches for the best possible price. When the price is found, the server quickly routes the order to the ECN and the trade gets executed. Network connections with SmartBook are faster because the links run through high-speed backbone networks from Archipelago's servers direct to each ECN.
SmartBook sounds great, except that to use it you need to sign up with a direct-access broker. Here's a
list of brokers providing access to Archipelago. So far, no major mainstream broker links to Archipelago.
Another ECN called RediBook incorporates a network-based smart-order routing feature similar to SmartBook. A glance at this ECN's partners/investors reveals some formidable names -- among them
. So far these brokers have been cagey about whether they intend to link with Redi during regular market hours. Some may offer after-hours access to Redi.
Why not earlier? During the day, market makers provide brokers with payment for order flow -- basically a kickback to the broker in exchange for its customers' trades. (For a full explanation of payment for order flow, see this recent TSC
story.) So linking up with Redi during the day would enable customers to bypass the market makers and cut into these brokers' profits.
For now. One day competition may force mainstream brokers to give their customers better access to ECNs, ensuring that their customers have access to decent executions. Meanwhile ECNs themselves will try to stave off competition by continuing to provide innovative new features. "If ECNs don't differentiate themselves through some kind of value-added feature such as smart-order routing, they won't be able to survive," says Stiffler.
Bad news for them, maybe. Good news for their customers.