With what do daytraders “eat” ECN?

I decided to highlight the topic about the American electronic trading systems. The Internet has a lot of all kinds of information on this topic, but it is rather superficial, and often does not provide understanding of the ECN functioning, as a part of the infrastructure of such markets as NYSE , NASDAQ и AMEX. Pseudo ECN forex brokers make it for traders even more confusing.

What exactly is American stock market?

Roughly speaking, the U.S. markets are composed of many electronic trading platforms, on which the stocks are being traded. For example, let’s take the INTC (Intel Corp.) stock, which is listed on the NASDAQ stock exchange. Trade of this stock is taking place not only on NSDQ, but also on other platforms (ARCA, BATS, Direct Edge, NYSE) and exchanges, such as BOSX, PASX, PHLX. Stock price may be different depending on the availability of orders for purchasing and selling on different platforms. For getting the best price when buying or selling shares, there is a NBBO (National Best Bid and Offer) rule. This rule usually binds together all the disparate ECNs, and allows you to get a better price due to orders routing when sending market orders.

Rough scheme of the of American stock exchanges infrastructure

[lightbox_link wrapper=”true” link=””]Infrastructure_NYSE_NASDAQ[/lightbox_link]

Level II и NBBO

In order to understand what routing is, and why is it needed to fulfill the NBBO rules, we should better understand a Level II or the so-called Order book. In simple terms, the Level II – is the book of sum orders from all exchanges and ECNs, i.e. in Level II we see how many lots, and at what price are located on each of the ECNs. The easiest way to deal with Level II, orders routing and NBBO is to make an example with a particular stock.

Screenshot of the Level II from the Takion terminal on FDO stock

[lightbox_link wrapper=”true” link=””]ECN book Takion[/lightbox_link]

Leftwards there is a group of orders for purchasing at different ECNs at different prices, rightwards – the same, but for selling the orders. At the moment, we see that the best offers that are located at BATS EDGX and cost $1 for each lot. Let’s suppose we send an order to Buy Market with 500 shares on EDGA. What will happen in this case? First of all, once the order has got on EDGA, there is an immediate comparison with open liquidity on other ECNs. Search algorithm of this liquidity to meet the NBBO rules is called routing.
At the moment of routing the order passes a certain route in search of better price. Primarily, liquidity for the order execution is seeking, of course, on the ECN from where you sent it. But then everything is a bit more complicated: the search for liquidity will go on certain algorithms. I.e. firstly, we look in one place, and then in another, then in the third one, and at the same time we are taking into account priority of the liquidity (looking for hidden or open). Each ECN has a different set of routes for searching. Possibility to use these routes depends primarily on the broker and trading platform. In this case, most likely the execution will take place by EDGX (EDGA is routing primarily there).

What is liquidity?

In this context liquidity is the orders of other traders, market makers and other participants of the bidding. There are two stable concepts related to liquidity: the removing liquidity and adding liquidity. For many of you these things are not entirely clear, and I’ll tell you a little bit more. Any transaction is a matching of two, opposite in the direction, orders (one – to buy, another – to sell). Any Exchange understands only two orders: limit and market (stop-orders are the kind of market orders with a trigger).

How the trade is usually conducted?

Most often, one participant sets his limit order at a certain price, and the other party sends a market order, which overlaps just by a limit order. Exactly like this, in 95% of cases the buyer and seller find each other and close the trade. Of course, the variant of the matching of two market orders is possible, but it is quite rare. Adding liquidity is a setting of a limit order, which will hold on for at least 2 seconds. Removing liquidity is a market order execution, either a limit order, which didn’t hold on for 2 seconds (e.g. Buy limit at offer price).

How do the ECNs differ?

There are three ECN criteria:
1. Liquidity: how much is traded on a particular ECN, how many orders there are and what are the price breaks. Most liquid are BATS, ARCA, EDGX, NSDQ.
2. Costs of performance: how much to pay for a performance at the particular ECN. More information about the prices is described below.
3. Routing Routes: Each ECN has its own set of mechanisms. How and which one to choose will be described below.

How to choose the right ECN to send orders?

First, you have to decide, what this order will do – remove or add liquidity.

To add liquidity you need to use ECNs that are paying for adding the liquidity. Estimated cost of ECN can be foundhere. So, to add liquidity (for passive limit orders) ARCA and BATS are suitable. For the execution of an ECN order they will pay 21 and 25 cents per 100 shares, respectively. The very important point is that when you send a passive limit order (i.e., one that does not change the quote), the routing will go towards you, but not from you. If you set the order on BATS – it will be executed there.

There are few delicate moments about setting the limit orders for adding liquidity:
1. In thick and non-volatile stocks, limit orders on BATS and ARCA will be executed at the end of the line because of the high competition from robots. Actually, the ECN business is built on the difference in commission for removing liquidity and rebate for adding liquidity. I.e. if on BATS you will get a high rebate for adding liquidity, for the removing liquidity there, you will pay more (29 cents). That is why the high-volume shares market orders primarily go for cheap (in terms of removing liquidity) ECN, and only then go on expensive ARCA and BATS.
2. For the expensive and volatile stocks it is much easy to get a rebate due to larger number of micro-movements and inefficiency.
3. Fastest way to get the position on ECN, where the removing liquidity is cheap or rebate goes for it (e.g., EDGA), is due to the limit order.
4. For cheap stocks the liquidity may often be higher on BATS comparing to ARCA. This happens due to the higher relative cost of order execution (if recalculated on the same value of the shares).

Now let’s talk about orders for removing liquidity. First of all, this is market order and stop order. When sending market orders there is always a search of liquidity – routing of order. Order execution will always be held in the place where the liquidity at the best quote (usually NBBO) was found. Payment will be made at the prices of that ECN, in which the trade was made. Therefore, when setting up a market order it is necessary to consider two things: ECN liquidity and its cost. Usually, high liquidity improves cost of execution on particular ECN, and you need to find a correlation between these parameters.

Here are a few options for setting the market orders:

1. Cheap execution for small orders. If you trade enough liquid stock with 1-2 lot, then the risk of strong slipping due to the routing time is small and you can use the cheapest ECN (they have the same low liquidity). This is primarily EDGA and BATY. Approximately in 1-2 cases of 5, you will receive execution at EDGA, and in other cases there will be routing and execution on other platforms. If there is an open liquidity on EDGA in the Level II, it makes sense to send the order out there and get fast and cheap execution. BATY is less liquid. Both ECNs pay for the removing liquidity (if the order is executed exactly on them!)

2. Relatively cheap performance for large orders. If you frequently send order for 500 shares or more, then EDGA will unlikely provide good performance without a strong slippage. First, such amount can be found on EDGA in the Level II quite rarely, and, secondly, routing of a large order may take more time. There are two ways for sending such orders: to find the classic open ECN liquidity (it is more expensive) – e.g., NSDQ, or to seek liquidity on dark pools with aggressive routing. Second option is more interesting. By using the dark pools the commission for execution will be a little higher, but sometimes you can get one cent (or less) better price than the current one, and also very fast. Good option – dark pool NITE with FAN routing.

3. Expensive and fast execution. If you want to get the position quickly, especially in illiquid stocks, the easiest way is to use the most liquid ECNs. The possibility of routing is much less and as a result, it is possible to slip below.

Everyone must adjust orders for themselves. Probably you will not find a general solution. For the beginners I can give a piece of advice to set for the market orders NSDQ or EDGA. Actually, the logic of ECN selection is always simple – the faster and better you want to execute the order, the more you will have to pay.

Here are few words about routing.

In some terminals, you can choose a ready route for sending the order, i.e. ECN sequence when searching liquidity. Usually, if to dig quite well, the description of routs can be found on the ECN website, to which this route belongs. The Takion terminal everything is more trader-friendly – if ECN is selected then you can immediately choose the route for it, and even a brief description.

[lightbox_link wrapper=”true” link=””]Routing[/lightbox_link]

Wish you a profitable earning season and good trading ideas!