Introduction to ECNs, Crossing Networks and Alternative Trading Systems

INTRODUCTION TO ECNs

Electronic Communication Networks and
Crossing Networks and Alternative Trading
Systems

© Prashant Ram All rights reserved.
This document may not be reproduced or distributed in part or whole without written
consent of author.

Table of Contents

Introduction ......................................................................................................................... 3
ELECTRONIC COMMUNICATION NETWORKS (ECNS) ....................................... 3
CROSSING NETWORKS (CNS) .................................................................................. 5
OTHER ALTERNATIVE TRADING SYSTEMS (ATS) ............................................. 8
Block Trading Systems ................................................................................................ 8
Electronic Systems in the Bond Market....................................................................... 9
Hybrid Systems ............................................................................................................ 9
NYSE ELECTRONIC TRADING.................................................................................. 9
SuperDOT and Anonymous SuperDOT....................................................................... 9
NYSE Direct .............................................................................................................. 10
NYSE Broker Systems ................................................................................................ 10
SMALL ORDER EXECUTION SYSTEM (SOES)..................................................... 11
INTERFACING WITH ECNS ..................................... Error! Bookmark not defined.

Copyright © Prashant Ram All rights reserved
This document may not be reproduced or distributed in part or whole without written consent
of the author.

Introduction
Having examined the financial markets, their microstructure and their order
executions, we now turn our attention to current electronic trading systems and their
role in the financial markets. The NASDAQ is a fully electronic exchange dependent
on electronic trading systems to conduct its daily transactions. The floor brokers and
traders on the NYSE use the latest in trading technology to conduct business
efficiently. Trading technology and trading systems come in a variety of forms,
addressing the different needs of the market. The most prominent electronic trading
systems include the ATSs or Alternative Trading Systems1, which are generally
grouped into two categories; the Crossing Networks(CNs) and, the Electronic
Communication Networks (ECNs). Besides the ATSs, technology plays an important
role in the trading envirionments between brokers and their institutional investors
and also on the floor of major stock exchanges.

ELECTRONIC COMMUNICATION NETWORKS (ECNS)

ECNs2 are computerized systems that automatically match orders between buyers
and sellers and serve as an alternative to traditional market making and "floor
trading”.

Although initially developed as private trading systems for institutional investors and
broker-dealers, today ECNs have a wide variety of subscribers including retail
investors, institutional investors, market makers, and other broker-dealers. ECNs
primarily facilitate trading in NASDAQ securities and limited trading in listed
securities (owing to additional regulatory rules for listed securities).

ECNs allows a 24-hour market, permitting extended hours3, pre-market4 and after
hours5 trading. ECNs currently handle over 38 percent of all NASDAQ volume, five
percent of all listed volume and almost all extended-hours volume 6.

1
The SEC (Securities and Exchange Commission) defines an ATS as any organization, association,
person or group of persons or a system that maintains or provides an electronic marketplace or
facilities for bringing together purchasers and sellers of securities.
2
The SEC defines an ECN as “any electronic system that widely disseminates to third parties orders
entered into it by an exchange market maker or over-the-counter ("OTC") market maker, and
permits such orders to be executed in whole or in part”. This does not include Crossing Networks.
http://en.wikipedia.org/wiki/Electronic_Communication_Network
of the author.

The current ECNs in operation are linked to the NASDAQ National Market System
through SelectNet. In the last few months the ECNs have seen several mergers and
acquisitions, and today the six major ECNs survive. These are Inet7, Bloomberg's
Tradebook8, Archipelago9, NASDAQ-BRUT 10
, Attain11 and NexTrade12.

ECN subscribers can enter limit orders13 into the ECN, usually via a custom computer
terminal or a direct dial-up, which is entered into an order book. The order book is a
listing of buy and sell orders pending for each stock for all subscribers to view
(investors can watch on their computer screens as their brokers input the bid or ask
in the order book). The ECN will then match contra-side orders for execution and as
buyers and sellers are paired up, trades are executed and the orders are taken off
the book. In most cases the buyer and seller remain anonymous to each other, with
the trade execution reports listing the ECN as the contra-side party.

ECN subscribers may use such features as negotiation or reserve size, and may have
access to the entire ECN book (as opposed to only the "top of the book"). Viewing

3
Extended-hours trading encompasses any securities transaction that occurs outside the regular
trading session, universally accepted as the period between 9:30 a.m. and 4 p.m. Eastern time.
4
Pre-Market trading encompasses any securities transaction that occurs prior to the 9:30 a.m.
Eastern time regular session open, generally accepted as the time frame running from 7 a.m. to
9:30 a.m. Eastern time.
5
After-hours trading encompasses any securities transaction that occurs after the 4 p.m. Eastern
time regular session close and generally extending until 8 p.m. Eastern time
6
http://www.midnighttrader.com/resource_faq.html
7
In 2002 Instinet and Island ECNs merged creating Inet
http://about.reuters.com/newsreleases/art_23-9-2002_id1065.asp
8
http://www.bloombergtradebook.com/
9
Archipelago bought REDIbook in March 2002.
http://www.thestreet.com/markets/marketfeatures/10013561.html
In April 2005, Archipelago announced merger with NYSE.
10
http://www.fisd.net/news/SINNASDAQBUYING%20BRUT.htm
NASDAQ acquired Brut LLC and Brut ECN in 2003.
11
Attain ECN, Domestic Securities Inc. http://www.dom-sec.com/ecn/ecnFeatures.cfm
12
http://www.nextrade.com/
13
An order placed with a brokerage to buy or sell a predetermined amount of shares at a specified
price or better. Limit orders also allow an investor to limit the length of time an order can be
outstanding before being canceled. Limit orders typically cost more than market orders.
www.investopedia.com

of the author.

the entire order book prior to trading enables investors gauge the "depth of the
market"14 in a stock.

CROSSING NETWORKS (CNS)

CN addresses the need of certain type of traders ready to sacrifice immediacy and
execution guarantees so as to obtain low execution cost. In crossing systems15,
traders enter unpriced (buy or sell) trades, which are crossed at pre-specified times,
at prices determined in the security’s primary market. Since the trades are unpriced,
such systems do not provide a direct price discovery mechanism. Moreover,
immediacy is not guaranteed since crosses take place only at a few discrete points in
time, and if there is an order imbalance, the trade may not be filled.

Crossing services to institutions are provided by three entities. First, the New York
Stock Exchange’s Crossing Session I crosses trades in individual stocks between
4:15 p.m. and 5:00 p.m. based on the NYSE closing price. Second, Instinet
Crossing (not to be confused with Instinet’s ‘‘day’’ ECN system) crosses listed
stocks at the closing price on the NYSE, and Nasdaq stocks at the closing inside
quote midpoint. Instinet Crossing is an after-hours cross with no preset time, but
trades usually take place between 7:00 p.m. and 8:00 p.m. Finally, the most
prominent crossing system is ITG’s POSIT16. Currently, POSIT crosses trades eight
times during the trading day in the US markets —at 9:40 a.m., 10:00 a.m., 10:30
a.m., and hourly from 11:00 a.m. to 3:00 p.m. EST. In day crosses, the prevailing
quote midpoint in the stock’s primary market serves as the crossing price, whereas
in after-hours crosses, the closing price of the security serves as the crossing price.
Consistent with our interpretation that crossing systems rely on a pool of liquidity in
the underlying market, the timing of the new matches follows closely the periods in
which the NYSE experiences heavy volume.

14
The number of orders and price levels on the buy and sell sides.
15
In its regulations, the SEC (SEC~1998, footnote 37) defines a crossing network as a system “that
allows participants to enter unpriced orders to buy and sell securities. Orders are crossed at
specified times at a price derived from another market.”
16
POSIT: Portfolio System for Institutional Trading (Posit)

of the author.

CNs use a Matching Algorithm to choose from the pool of orders to match orders to
contra-orders. A random execution time within a five to seven minute window is
generated from the POSIT computer to mask the exact time of the match. Any order
received before the designated match time is included in the match pool, but any
order received after the start of the match window is taken on best endeavor basis
up to the time the match is run. Any order received subsequently is scheduled for
the next scheduled match. Orders are aggregated and passively matched by the CN.
If there is an imbalance, orders on the excess side are randomly selected to match
the number of orders on the smaller side. Orders that are not selected do not
execute. For example, if there are orders to buy five units and sell three units, all
three units are sold and three of the five buy units are randomly selected and
executed. The matching algorithm is set to maximize the total value of shares
traded, given the constraints associated with the submitted order.

When both markets coexist, each trader has to decide whether to submit her order
to the DM (Dealer Market) or to the CN. Following common market practice, the two
markets are not mutually exclusive: traders can take advantage of both markets by
first using the CN and—if their orders are not executed on the CN—subsequently
going to the DM. Traders’ decisions are based on their value to trade, the costs in
each market, and their estimates of the probability of execution on the CN.

ECNS have not developed in Europe where only CNs predominate. In her paper
17
Gresse examines the effects of CNs on the structure of financial markets and the
role of financial intermediaries independent of other ATSs. On 18 Nov 1998 POSIT
adopted was by ITG Europe and it currently operates for eleven European countries.
In March 2000 Merill and Barcleys global investors launched another CN called the E-
crossnet. However POSIT still remains the largest CN in European markets the main
part of POSITs order flow is related to mid and small caps.

The potential benefits of CN trading rest on the lower execution costs the CNs offer,
which are usually much less than full service brokerage commission. CN participants
obtain lower implicit costs since they trade at the mid-point of bid-ask (and not at
the extremes). And CN trading bears no price impact on the underlying security

17
Crossing Network Trading and the liquidity of a Dealer Market: Cream-Skimming or Risk Sharing
? Carole Gresse, Sept 2002, http://www.fese.be/delavega/2003/gresse.pdf

of the author.

because of anonymity and because the trade price is independent of order size.
However these potential cost savings are limited by the fact that CNs do not
guarantee trade execution and the total benefit from CN trading is the result of the
trade-off between cost savings and the non-execution risk opportunity cost.

Crossing networks have been criticized by some in the industry as parasitical, on the
grounds that they increase market fragmentation, do not add to price discovery and
simply look to the primary market to set the price at the moment their customers
execute a trade.

We find that crosses take place largely in listed securities whereas ECNs focus on
NASDAQ stocks. This separation is natural, given the trading mechanisms employed
by these systems. Since crossing systems provide no price discovery mechanism,
they need a good primary-market price discovery and a minimum threshold of
trading volume by participants on the system so that the pool of liquidity is
sufficiently large. The NYSE provides such a mechanism. ECNs, on the other hand,
provide active price discovery—a feature that is particularly important when the
primary market is relatively fragmented and has high bid-ask spreads. Therefore,
NASDAQ stocks provide a natural setting in which ECNs can compete with market
makers for order flow.

18
Studies indicate that in general, broker-filled orders are larger, broken up into
more trades, and have higher fill rates than orders sent to alternative trading
systems. The same study also concludes that the average size of orders sent to
crossing systems and ECNs is considerably lower than those worked by traditional
brokers. Furthermore studies find that orders sent to traditional brokers have higher
execution costs than those executed by alternative trading systems. Crossing
systems have lower realized execution costs than broker-filled orders but have the
lowest fill rate.

18
Institutional trading and alternative trading systems, Jennifer Conrad, Kevin M. Johnson, Sunil
Wahal, Journal of Financial Economics 00 (2003)
http://home.business.utah.edu/~finhb/FINANCE%207880/Readings/conrad-wahal.pdf

of the author.

OTHER ALTERNATIVE TRADING SYSTEMS (ATS)

Several other Alternative Trading systems proliferate current financial markets and
address alternative trading needs.

Block Trading Systems

Recent regulatory modernization and market structure changes have made it more
difficult for institutional traders to move large blocks of stock. Today the average
trade size has fallen by almost 67% since 1997 and the average execution size on
the NYSE, NASDAQ, NSX and ArcaEx is around 500 shares19 (see figure 2). Thus it
can take up to 375 executions to full in the average institutional block trade of
150,000. Also institutions require strict anonymity and minimum informational
leakage with no detrimental effect on execution quality while trading larger blocks of
stock. Trading using traditional brokers is not anonymous and can result in leakage
of information.

Figure 2: Average Trade Size on the NYSE

Today Block trading systems provides a solution by allowing clients to trade directly
with other institutional buyers while preserving trading anonymity. Pipeline Trading
Systems’ Pipeline Block Board
enables institutions and brokerage firms to quickly and efficiently trade blocks of
NYSE - listed companies, NASDAQ stocks, and Exchange Traded Funds (ETFs).while
maintaining privacy of trade. Instinet’s Block Trading Slutions by Institnet is another
block trading sytem that allows institutions to trade blocks that are 23 times the
average NYSE trade size and 17 times the average NASDAQ trade size.

19
NYSE average trade size declined in 2003 and 2004. This continues a trend that started in 1997
with the introduction of the Order Handling Rules and accelerated in 2000 with decimalization.
http://www.instinet.com/pdf/pure_solutions/02_Block_1204.pdf

of the author.

Electronic Systems in the Bond Market

Though traditionally the OTC bond market has been highly people intensive
developments in IT are changing the landscape of the bond market. As early as the
1990s electronic information systems like the GovPx and FIPS (Fixed Income Pricing
System) <ref> were introduced in the bond market. In 1992 Credit Suisse First
Boston’s Gov Trade system used Bloomberg terminals to access quote information
and trade bonds such as treasury securities, repos and even commercial paper.
Other electronic bond trading systems include Autobahn by Deutsche Bank , LMS by
Merill Lynch, TradeWeb, Chicago Board of Brokerage’s MarketPower, Bloomberg’s
20
BondTrader (a component of Bloomberg’s Electronic Trading System , Instinet’s
21 22
Fixed Income Electronic Brokerage and State Street’s BondConnect

Hybrid Systems

OptiMark is an alternative trading system that allows electronic matching for trading
equities. Launched on San Francisco’s Pacific Exchange it is able to link markets and
allow investors to trade baskets of securities across different exchanges in a single
transaction without the risk of partial execution. OptiMark effectively creates a hybrid
market structure, integrating the continuous market with periodic call auctions. In
this model, there is a continuous, displayed order book, and every 10 minutes or so
the orders are swept into OptiMark to be matched, along with orders that have been
submitted directly into the OptiMark engine. Any book orders which don’t get filled
are returned to the book.

NYSE ELECTRONIC TRADING

SuperDOT and Anonymous SuperDOT

SuperDot or Designated Order Turnaround is an electronic order-routing system used
by NYSE member firms to send both market23 and limit orders24 directly to the

20
In the fourth quarter of 200, BondTrader was expanded to include the buying and selling of global non-
dollar soverign issues and US agencies on the same platform.
21
http://www.progress.com/realtime/docs/analyst/instinet_case_study_sun.pdf
22
BondConnect is a complete fixed income electronic marketplace which opened in June 2000
23
An order to buy or sell a stock immediately at the best available current price
A market order guarantees execution, and it often has low commissions due to the minimal work
brokers need to do. A market order is sometimes referred to as an unrestricted order.

of the author.

trading post where the security is traded. After the orders have been executed,
SuperDot uses the same electronic circuit to send post-trade reports back to the
firms.

Ninety-nine percent of all orders pass through SuperDot and it reliably meets NYSE’s
ever-increasing demand, which currently stands at 6 million quotes, 13 million orders
and 5 million reports daily.

Anonymous SuperDot® (ADot) enables institutional investors sponsored by a
member firm to submit orders directly to the NYSE without the Exchange, member
firm, specialist or floor brokers knowing their identity. The institution and its
sponsoring member firm must establish parameters within which trading can occur,
including a trading limit expressed in dollar value and a maximum order size. The
institutional investors receive transaction reports as and when they occur, while the
member firms receive a copy only at the end of the day or after an agreed-upon time
has elapsed, for clearing purposes.

NYSE Direct

NYSE Direct+ is an automatic-execution service for limit orders of up to 1,099 shares
that enables users to opt for an immediate execution at the best bid or offer, without
a fee and with anonymity and speed. The average execution time is 0.36 seconds.
Slightly more than 10 percent of total NYSE daily share volume is executed
automatically via Direct+ which is more than the volume of all of the current
electronic communications networks (ECNs) combined.

NYSE Broker Systems

NYSE's Broker Systems give brokers the tools they need to be faster, more flexible
and more efficient, helping them meet heavier trading volumes and the ever-
increasing demand for fast trade execution. These include the following Order
Management systems and related tools that facilitate the daily voluminous
transactions.

24
An order placed with a brokerage to buy or sell a predetermined amount of shares at a specified
price or better. Limit orders typically cost more than market orders.

of the author.

The Broker Booth Support System® (BBSS is a strategic, full-service order
management system (OMS) supporting straight-through electronic order processing
25
(STP ) and reporting for member firms on the floor of the Exchange. With BBSS, a
member firm can choose to route orders electronically directly to the trading post or
to a floor broker.

NYSE e-Broker® is a wireless handheld order-management tool that helps floor
brokers trade faster and more efficiently while staying connected to their firms' floor
booths and trading desks. With the e-broker brokers can receive and view orders,
electronically send orders to the specialist display book, track messages, retrieve
market information and carry out various other related transactions.

A new and more powerful order management tool called NYSE Tradeworks is in its
pilot stage and is slated to offer full order management capability, the same
functionality as BBSS but with greater scalability, rich, new features and an improved
user interface.

SMALL ORDER EXECUTION SYSTEM (SOES)

SOES is an automatic order execution for individual traders with orders less than or
equal to 1000 shares. The lack of liquidity after the 1987 market crash lead the
NASDAQ to implement this mandatory system to provide automatic order execution
for individual traders with orders less than or equal to 1000 shares26.

There are several restrictions for those who are using SOES, rather than a traditional
ECN, to place their orders27.
1. Trades may not be in excess of 1000 shares for a particular stock.
2. SOES doesn't not allow trades in stocks that are trading at prices greater than
$250 per share.

25
STP (Straight Through Processing), the ability to process a stock transaction by computer
from beginning to end without manual intervention at any of the stages. Presently only a concept,
STP represents a major shift from present day T+3 trading towards same day settlement by
removing redundant operations and utilizing electronic transfers.
http://www.answers.com/topic/straight-through-processing
http://en.wikipedia.org/wiki/Straight_Through_Processing
26
http://daytrading.about.com/library/weekly/aa043001a.htm
27
http://www.investopedia.com/university/electronictrading/trading6.asp

of the author.

3. Once a trader places an order through SOES, they must wait at least 5 minutes
to place a trade through SOES on the same stock.
4. Short selling through SOES must comply with SEC rules and be on a zero plus
tick28 only.
5. Institutions and brokers are not allowed to place orders for their own accounts
through SOES, but they can for a client's account.
6. Market makers must honor their advertised bid/ask prices to SOES orders,
provided that they are for the amount that the market maker is looking for.
The Automatic feature in SOES continues to provide liquidity in the market through
small orders even if the market makers are reluctant to take a risk in a falling
market.

These and several other electronic trading systems currently proliferate the finance
industry. They facilitate the voluminous trading, provide security and anonymity, and
have become the very lifeline of today’s financial markets.

28
A transaction at the same price as the preceding trade, but at a higher price than the last
different trade. Also known as a zero uptick. For example, when trades are executed at $10, $11,
and $11, the last trade at $11 is a zero-plus tick. A short sale is only permitted on a zero plus tick.

of the author.

Introduction to ECNs, Crossing Networks and Alternative Trading Systems

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