Electronic Communication Network (ECN) Explained
Forex is an OTC Market
Forex spot trading is an OTC practice (over-the-counter), and that means the transactions are not cleared in a single exchange, like for example transactions are cleared in the New York Stock Exchange.
The FXMarketSpace Experiment in 2006
In 2006, the Chicago Mercantile Exchange (CME) and Reuters launched the FXMarketSpace (FXMS) which was the world’s 1st centrally cleared forex market. In 2008, they decided to close this innovative platform due to limited attracted liquidity.
The Electronic Communication Network
In general, ECN is an electronic trading platform designed to match long and short trading orders automatically. In the Foreign Exchange Market, ECN works as an electronic bridge linking tier-1 liquidity providers with Retail Traders. The whole process is done via an ECN Forex broker. The liquidity providers of ECN Forex trading consists central banks, retail and investment banks, investment firms, market makers, retail and institutional Forex traders, and etc.
The Role of an ECN
An ECN network is designed to collect, display and execute trading orders automatically without any intervention. Trading on an ECN network provides tight spreads, fast order execution and full anonymity.
Electronic Communication Network Basic Features
These are some key points that differentiate trading via the Electronic Communication Network to other trading practices.
(1) Variable Spreads
Spreads between ask and bid when trading via an Electronic Communication Network are variable and change according to the market volatility. Volatility usually changes during news releases or after important economic and political developments. Only those brokers who act as Market Makers (Dealing-Desk) can offer fixed spreads. The problem with fixed spreads is that they are followed by high re-quotes on at times when the market volatility soars. Therefore, the advantage of fixed spreads is lost. True ECN Forex brokers are offering variable spreads and don’t charge any re-quotes.
(2) Anonymity of Trading
The trading activity of an Electronic Communication Network is totally anonymous. Trading anonymity means that every participant trades on the exact same conditions (neutral prices). In other words, real market conditions for all traders, no matter their trading volumes and their account size. This creates an environment of reliability in favor of retail traders.
(3) Huge Liquidity
As the whole planet trades Forex currencies via the Electronic Communication Network, it is extremely difficult even for huge players such as large investment banks to manipulate the market. Moreover, the huge liquidity ensures the fulfillment of any order, even when market conditions become real tricky. Of course, there is no rule without exemptions, and therefore, once in a couple of years, there might be problems in the fulfillment of trade orders. These problems usually occur after weekends and that is why professional traders do not maintain their positions after the closing of Friday.
(4) Volume Activity can’t be Measured Precisely
As transactions of an Electronic Communication Network aren’t cleared by a central system, there is lack of summarized volume data.
(5) Time Zones and GMT
Forex traders around the world are living in locations of different time zones. Therefore, there is a little bit of confusion regarding when the market opens and closes on a daily basis. As a result, many traders use the Greenwich Mean Time (GMT) on their charts.
ECN Forex Market Participants
Here are the key players of the ECN Foreign Exchange Market:
(a) Central banks
Central banks are serving the important role of monetary stabilization and therefore often interfere in the market. They can interfere directly by buying or selling currencies or they can interfere indirectly by applying interest rate policies or by making comments regarding their domestic currencies or by publishing certain macroeconomic forecasts. The central banks are keeping reserves of Foreign Exchange currencies as their assets. The greatest Forex reserves are kept by the Bank of China (3 trillion USD) and the Bank of Japan (1.2 trillion USD). These two particular central banks are notorious for their interference in the Forex market.
(b) Retail Banks
Large Tier-1 banks are key players in the Foreign Exchange Market. These banks handle transactions of billions of dollars on behalf of their clients (large companies, institutions, etc). Moreover, they handle their own trading orders via their Dealing Rooms. These major banks include Citigroup, Deutsche Bank, Barclays, HSBC, BNP Paribas, etc.
(c) Large companies
Many large corporations trade the Foreign Exchange Market. Their transactions may involve investing their corporate wealth, or hedging the risk deriving from activities in foreign currencies. Fluctuations of Forex currencies create “Market Risk” and corporations are always trying to avoid unnecessary risk. Multinational companies or major importers / exporters are often traders in the Forex Market. These companies may trade through banks and avoid accessing the ECN Forex market themselves.
(d) Forex Brokers
Forex Brokers actually link retail traders with the ECN Interbank market. ECN/STP brokers simply transfer their client orders to the ECN market without interfering. For that job, they usually charge their clients with volume-based commissions. Brokers using a dealing-desk create a market within a market and don’t transfer their client orders in the ECN network. But there are some market makers that may trade on the interbank market through credit links with banks. They may use this linkage to hedge some risk against large client orders. Market-makers also access the ECN Forex market for pricing using platforms such is Reuters.
(e) Institutional Traders
Institutional traders include investment companies, Forex hedge funds, and other similar institutions. Their goal is to speculate and to take advantage of Forex market inefficiencies. This category of traders can be pretty aggressive. Who can forget the case of George Soros who traded against the monetary policy of the Central bank of England and made billions of dollars by collapsing the British Pound Sterling.
(f) Retail Traders
There are tens of millions traders taking positions in the Foreign Exchange market. These traders use ECN/STP Forex brokers or Market Makers to link with the global currency market. This category of traders is very active nowadays.
■ Electronic Communication Network (ECN) Explained