Study finds ECNs benefit investors

by David Roeder

When a Nasdaq-listed stock changes hands, the chances are growing that the trade isn’t executed on the Nasdaq system. Individual investors are better off for the trend, a finance professor at the University of Notre Dame concludes from research.p. Prof. Roger Huang tracked trading of the most active Nasdaq stocks and found that buyers and sellers frequently got better prices on electronic communication networks, or ECNs. The networks allow investors to bypass Nasdaq market makers and trade stocks directly, often at lower cost.

The largest ECN, with 16.8 percent of the ECN trades, is Instinet, which is dominated by market makers. At No. 3, according to Nasdaq data, is Chicago-based Archipelago, with 7.2 percent of the trades. The business is consolidating, with Instinet acquiring the Island ECN, and Archipelago taking over No. 2 player Redibook, which has 8.9 percent of the trades.

Nasdaq’s figures show ECNs account for more than 40 percent of trades in its stocks. Huang said ECNs usually offered stock quotes at a tighter spreadthe difference between bid and offer prices-compared with Nasdaq’s dealer quotations. He also said changes in quote were posted more quickly on ECNs.

As the ECNs proliferated in recent years, Wall Street pros worried that market fragmentation would lead to wide variations in quotes among different networks. Huang said his study, published in a recent issue of the Journal of Finance, suggests the concern is misplaced. "ECNs are not messing up the market by fragmenting it,‘’ he said. "They are contributing to the whole market’’ by helping investors better determine a stock’s fair value.

Unlike Nasdaq or the New York Stock Exchange, ECNs post several levels of bids and offers, not just the best of each. Huang said ECNs also offer an advantage in customer anonymity, something established exchanges are now introducing. That means market makers can’t see that Merrill Lynch, for example, is buying massive quantities of IBM.

“If you are buying, you don’t want to be identified because the price is going to move against you,’’ Huang said.

Instinet and Island, the favorite among individual traders, offer the most liquid markets, Huang said. He said Archipelago is trying to muscle in with unique software that searches competing networks to find the best matching price.

Huang said ECNs will continue to pressure established exchanges. He noted that Nasdaq and the NYSE are introducing systems that follow the ECN model in providing anonymity and multiple levels of quotes.

August 13, 2002

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