Function

• In a traditional stock exchange environment, floor traders bid through a standard auction process for the purchase and sale of stock. Among these traders are the "market makers" which ensure that everyone who wants to sell will find a buyer, and those who want to buy find a seller. Thus, those who hold shares in a stock that is rapidly declining can still sell to the market makers, who literally "make a market" for that seller when no other buyers are present. The ECN removes this middle man, the human market maker, and replaces them with a computer network that matches buyers and sellers automatically.
  
  

History

• The first ECN was actually created for the Nasdaq exchange in the 1970s. Unlike other exchanges, such as the NYSE, the Nasdaq does not have a central trading floor, and all transactions are handled electronically. However, some human intervention still took place in the Nasdaq, and it was discovered in the 1990s that these traders has considerable advantage over the electronic participants. The SEC responded with new regulations governing electronic trading in 1997. This resulted in new laws permitting the creation of additional ECNs to encourage competition.
  
  

Benefits

• Due to the limited number of human market makers, the transactions that occur in active stock markets are not always efficient. The spread between the "bid" and the "ask", that is, the difference between the price a stock can be bought versus the price it can be sold, are often high when human market makers are involved. This is due to less liquidity. When ECNs handle transactions, the bid-ask spread is reduced to nearly zero. This makes it less costly to both buy and sell stock, which benefits individual traders as well as institutions. Additionally, an ECN can function outside normal exchange hours. This makes it possible to provide better after hours stock transactions during the extended market sessions.
  
  

Participants

• Before the SEC policies of 1997, The Nasdaq was the only primary ECN in play. A small Nasdaq subnetwork called Instinet was controlled by traders who took advantage of loopholes in the Nasdaq system. After the new laws, Instinet became a separate ECN entity. The first new ECN to then appear was Island. These two ECNs were the first legitimate participants in these new industry practices, and competed with each other for transactions. Others soon emerged. Archipelago was formed that same year and provided an innovative system that interacted with any other ECN, thus providing its clients the greatest guarantee of liquidity. The success and size of Archipelago eventually led to its status as an independent exchange. The fierce competition among ECNs has seen many come and ago. Even the first ECN, Instinet, did not last long as Island proved more efficient and quickly acquired must of Instinet's business.
  
  

Level II

• Many traders employ Level II stock quotes in their trading platform. This is an added feature that provides more information about the electronic auction process that is governing their work. Whereas normally a trader will not know how their stock order is routed, those using Level II quotes can specifically see what ECNs are participating in a particular stock. Level II quotes provide not just the current bid and ask prices for a stock, but also all the dormant orders that are waiting should that stock move up or down in price. These orders are grouped together according to their ECN. This makes it possible to see what kind of interest actually lies in the market. If a large ECN is poised with many stock buy orders, it suggests that large institutional buyers may be preparing for a significant rise in the stock's price. If the ECN with these orders is instead a smaller outfit, the orders do not carry as much weight.