ECN System vs. Market Maker – What is Best in 2023

The financial markets are complex entities with many different systems working together to keep things going as they should. There are the companies who are offering to sell their shares; there are the exchanges where you go to do your buying and selling; and there are the market participants, who do their best to come out with a few dollars by the end of the trading session.

From the perspective of those participants, there’s a choice to be made between two types of exchanges, each of which has qualities that may better fit his preferences. The traditional sort of exchange assumes a format called the Market Maker model. In this model, a bank or brokerage house decides to literally create a market for the benefit of participants. They do this by buying securities in bulk, holding them, and offering them up for sale at fixed prices.  Since these brokerages are themselves making the market for that security, they can determine the level of supply available and, in this way, control prices. The prices, however, aren’t just set according to the whim of the market makers. Rather, they are constantly adjusted to reflect (albeit indirectly) the dynamics of supply and demand for that particular security.

By way of comparison: Imagine someone who goes out to several fruit wholesalers and buys various kinds of fruit in large volume, which he then offers for sale at his own Sunday market. Since he’s an honest sort of fellow, he sets the prices of each type of fruit based on the wholesale prices he paid, rather than, say, randomly hiking the price of cherries in order to boost his earnings. Because this man’s market exists, local villagers have a place to go where they can quickly and easily purchase the fruits they want. Not only that: when a local jam maker starts buying fruits from the market to make her products, the market takes on a whole new significance. The presence of the fruit market is now helping sustain a larger arena of trade.

So it is when a brokerage or bank goes out and makes a market for securities, standing poised to sell or buy them at the trader’s command. Aside from offering a convenient service to traders, the broker is also pumping a stream of liquidity into the market, which improves its efficiency. Because the broker is there, the costs and risks of trading are kept low and it remains easy for traders to open and close their positions at will. The broker is good for the market because the market runs more smoothly with him around and, by extension, he is good for all those who depend on the market.

What is ECN?

An ECN (electronic communication network) is the other exchange model available to market participants. In order to understand the meaning of ECN, let’s continue with our analogy above. Imagine that a local villager preferred not to buy his fruit from the Sunday market. Instead, he wants to deal directly with the fruit wholesalers. There happens to be a man whose job it is to match the various wholesalers directly with consumers. When this man is told someone wants to buy a crate of peaches, he checks out the prices for this item at several wholesalers and then comes back to the consumer with the best price. This man is like the ECN.

An ECN system is an electronic platform that displays the optimum bid and ask prices for a security, matches the buyers with sellers, and then sends orders through for execution. In this way, through exposing traders directly to the pool of liquidity out there, the market maker is bypassed. One consequence of this is that the spreads (differences between bid and ask prices) for that security will be lower. Whereas the market maker will tend to widen the spread in order to receive compensation for the service he provides, the ECN is able to do away with the spread, sometimes completely. Certain traders may consider this a point of some value, especially if they trade with high frequency. Others might enjoy the relatively high speed with which ECN trades are facilitated. A third benefit would be the ability to trade after regular market hours, if this is important to you.

How do ECNs make their money, then, if not through the spread? The answer is through charging traders a commission on every trade. This, then, would be a downside in using ECNs that would balance out their tighter spreads. Putting this aside, it may seem to you that ECNs are obviously superior and that no one would reasonably choose a Market Maker model. After all, a Market Maker like a brokerage has the power to set prices to its own advantage. Since your broker acts as the counterparty for your trades, buying when you want to sell and selling when you want to buy, maybe he shouldn’t be trusted to deal straightly with you! In short, is there any reason someone would prefer the Market Maker model over the ECN model?

Benefits of Market Makers

The answer is yes, there is. To begin with, a Market Maker is able to offer its products at a discount due to having bought them in such large amounts. Beyond this, the Market Maker’s ability to set prices on his own is not always a drawback. It gives him the power to hike the price of a stock that is undervalued or depress the price of an overvalued stock. He can do the latter by increasing his inventory of the overvalued stock, or the former by decreasing his inventory of the undervalued stock. This would be to the market’s benefit.

If you’re a forex trader, you may also like the fact that currency price movements are less volatile when you use a Market Maker to execute your trades, than when you use an ECN. If your trading account is on the modest side, you may find that the smaller lots put on offer by Market Makers suit your needs better than those offered by ECNs. And, as we mentioned, if you’d like to trade free of commissions, a Market Maker may be the best way to go. It depends on which pricing model works better for you.

If you’re worried about your broker manipulating prices in order to get the upper hand over you, the solution is to ensure you use only regulated, licensed brokers with solid reputations in the business. Once you do so, you need not worry too much on this score. Trusted authorities are monitoring the broker to make sure everything they do is above board. Market Makers are also able to execute trades pretty quickly, particularly if they use low latency servers.

Choosing a Broker

As we’ve said, the question of which broker model to choose is a subjective one and depends on your preferences. Your trading strategy and style, for instance, could be important factors in informing your decision. Bear in mind that the market model of your broker is only one factor among many that should influence your choice. You’ll need to check out the account types available on various brokers before settling on one that suits you.

It’s also crucial to find out about the trading platform of your broker. Is it equipped with live charting technology? There are some ECN brokers who don’t offer the high quality technology for this that Market Maker brokers often do. Since this can make a big difference to your trading, ensure you do research on the point before signing up to a brokerage. When it comes to minimum deposits, you might also find that ECN brokers can be a bit stricter in this area.

Many brokers offer you the chance to try out their platform with the use of a free demo account so you can get the feel for it. This can be a valuable opportunity as it could help you in finally making up your mind, when the time comes. Some traders feel there is an element of human touch about the Market Maker model that gives it an edge over the ECN model, but this will ultimately be left to your own feelings to decide. Certainly, though, the broker platform you use should be user-friendly since this is the interface you’ll be dealing with on a daily basis. If you prefer the ECN model because it suits your strategy, but find the ECN broker’s platform is more difficult to use, as some people do, it may be better to go the traditional Market Maker route.

Summing Up

The Market Maker and ECN models are two different formats that trading brokerages can choose to adopt. Neither is inherently better than the other. In this article, we’ve tried to give you an outline of some of the main practical differences between the two models in order to assist you in making a choice. We’ve also reminded you to broaden the scope of your investigations to include the other qualities and features offered by brokers on their platforms.