The Forex or foreign exchange market is a global marketplace that does not have a single address or exchange to do business. This is unlike the stock market which has different exchanges that handle the execution of orders for the stocks registered with those exchanges.
Most Forex transactions take place within the Interbank market, which is a comprised of the largest banks in the world. Retail customers cannot participate directly with this exclusive market, but can trade in Forex currencies through either a Market Maker or an ECN.
An ECN or Electronic Communication Network is an automated system by which the best bids and offers are presented to traders based on the available quotes in the marketplace. ECN’s are generally used for trading of Stocks and Currencies. The original ECN, Instanet was developed for the stock market in 1969 with the purpose of increasing competition among brokers by lowering transaction costs and offering trading outside of exchange hours. It wasn’t until 1999 was the first ECN, Matchbook FX, was established for the currency markets.
ECN Forex Broker Advantages
- Tighter Spreads as Quotes come from multiple sources
- ECN’s don’t trade against you as they just direct trades to other customer
- Greater Price Volatility
- You can place orders in between Bid and Ask
- Real Time order book Information is displayed with all available Bid/Ask quotes
In order to understand what an ECN is lets take a step back to understand the alternative way that stock and currency orders are fulfilled.
Traditionally a person or company known as a Market Maker provides liquidity in a stock or currency pair by buying and selling assets which are being offered for sale or up for purchase. They gather the bids and offer and present a buy and sell price. They are required to buy or sell at the quoted bid or ask price to provide liquidity in the market for that asset.
There are two types of Market Makers, institutional and retail. Institutional market makers can be banks and large corporations that offer bid/ask quotes to different banks, ECN’s or to Retail Market Makers. Retail market makers are companies that offer Forex trading services to individual customers.
The retail market maker makes money on the spread which is basically set for each currency pair. They are able to buy or sell the currency at a better price than provided to their customers, thus making money on the difference. The spreads are usually reasonable based on competition between different firms.
The ECN is generally a passive computer driven system that matches customer orders that come in from multiple sources. A small commission is charged for each executed offer. By removing the market maker, who made money from price spreads, the price differential between the bid and ask is much tighter in the case of an ECN transaction.
The more traditional Forex brokers use the market maker model to process orders. There have been complaints that brokers trade against their clients orders. ECN brokers provide an advantage because they automatically route orders by computer to the best available bids and asks provided in the marketplace. The actual order book for each currency pair is displayed showing all the available bid/ask quotes. In this way they don’t actually participate in the purchase or sale of the asset, but just act as a conduit to execute orders between two parties. Although they charge a commission for each transaction, since the spreads are much tighter you gain on securing a better execution price.