1
Preparing for the Future An outline of
critical industry issues and emerging trends

• Presented by
• Larry Tabb
• Founder CEO
• TABB Group

2
Agenda

• The 4 Macro Trends
• Hedge Funds
• Regulation
• Exchange Consolidation
• Dark Pools
• Cost
• Conclusions

3
The big picture The 4 major macro market trends
4
Net corporate equity issuance hit a 20year
negative record as companies buy-back stock
5
Foreign markets over the past 2 years have
outperformed the US market
India
Korea
China
DAX
Japan
CAC
HK
FTSE
SP 500
6
Derivatives business are all at record levels
7
While mutual fund growth impressive, hedge fund
AuM growth has not escaped notice
Hedge Funds vs. Mutual Funds AuM CAGRs
AuM growth of Hedge Funds vs. Mutual Funds (in
US trillions)
Long Only Value Model .75 to 1.5 AuM Hedge
Fund Value Model 1 to 2 AuM plus 10 to 20
of profits
Source TABB Group Institutional Equity Trading
2006 Preliminary
8
Hedge Funds
9
Over half of managers have hedge funds 17 more
plan on launching one in next 2 yrs
Institutional managers launching hedge funds
(2006)
Institutional managers planning on launching
hedge funds by 08
Source TABB Group Institutional Equity Trading
2006 Preliminary
10
HFs inflows are becoming more institutional
2 Year Change
Who are your investors ?
2006
2008
Source TABB Group study Hedge Funds 2006 The
Quest for Alpha in an Increasingly Competitive
World
11
Market has been challenging for hedge funds as
they look to alter their strategies
Percentage of Hedge Funds Making Strategy Changes
in the Previous Year
Single vs. Multi-strategy Funds
Source TABB Group study Hedge Funds 2006 The
Quest for Alpha in an Increasingly Competitive
World
12
The bulk of hedge funds are adding strategies and
looking globally for alpha
What Changes Were Made?
Source TABB Group study Hedge Funds 2006 The
Quest for Alpha in an Increasingly Competitive
World
13
Funds are investing abroad and looking at other
kinds of asset classes
Additional Geographies and Asset Classes Past
and Present
Source TABB Group study Hedge Funds 2006 The
Quest for Alpha in an Increasingly Competitive
World
14
Most dramatic order flow shift will be from
internal algos to DMA broker-sponsored algos
Unweighted Order Allocation (Equity Only)
CAGR
Source TABB Group study Hedge Funds 2006 The
Quest for Alpha in an Increasingly Competitive
World
15
Regulation NMS
16
What are the National Market Structure
Regulations of 2005?

• The NMS regulations revolve around 4 major
  platforms
• Order Protection Rule (trade-through)
• Access rule
• Sub-penny rule
• Market data rebate policy change

Source TABB Group
17
NMS forcing exchanges to move toward electronic
trading

• NMS states that firms need to preference fast
  markets over slow ones
• Need to route to hybrid or ECNs over floor
• Incenting development / acquisition of a number
  of electronic exchanges and ECNs
• Announced electronic exchange efforts
• NYSE (hybrid), PHILX, BEX (Bos), Chicago, NSX
  (Cincinnati), Amex (hybrid electronic)
• New or newly acquired ECNs
• Attain gt Knight
• OnTrade (NexTrades ECN) gtCiti
• BATS

18
The NYSE Hybrid-Market, while electronic, is NOT
an ECN

• Trading in parity
• Specialist Algorithms
• Reserve Orders
• Speed
• Pricing
• NYSE already beginning to lose order flow
• Market share below 70
• Lowest in the 29 years they have kept stats

Source TABB Group
19
Unbundling / Soft Dollar Regulations
20
PS 05/9 FSA-based unbundling regulations

• Limit commissions to the purchase of
• Execution research services
• Requires IMs to disclose
• How commissions payments have been spent
• What services have been acquired with them
• Promote competition between research producers by
  
• Removing distinction between brokers (bundled
  services)
• Third parties providers (soft services)

21
Included / excluded

• Included
• Research services (original research only)
• Execution services
• Excluded
• Raw data feeds (without modification from the
  exchange)
• Post trade analytics (to the extent that
  analytical software meets research service
  criteria because it assists in the making of an
  investment or trading decision, it could be paid
  for with soft dollars
• Valuation or performance measurement software
• Computer hardware
• Dedicated phone lines

• Excluded Services
• Dedicated phone lines
• Seminar fees
• Subscriptions for publications
• Travel, accommodations, or entertainment costs
• Office admin software or word processing or
  accounting software
• Membership to professional organizations
• Purchase or rental of office equipment or
  facilities
• Employees salaries
• Direct money payments
• Publicly available information
• Custody services

22
Greater number of large firms banning soft dollars
Money Management Soft Dollar Trends
Source TABB Group Institutional Equity Trading
2005
23
Bundled soft payments to brokers expected to
drop while internal, indy, and hard payments to
rise
Expected Volume of Research by Payment Type
Source TABB Group The Future of Equity Research
24
Exchange Consolidation
25
From whence we come
NYSE
NASDAQ
Brut
Knight
Instinet
Instinet
Arca
Island
Citi
NASDAQ
Arca
Attain
Redi
Strike
Brut
TradeBook
NextTrade
BATS
26
Where we are headed
  BSE BOX ISX CSX CBOE BATS NSX Philx
Bank of America 1
Bear Stearns 3
Bloomberg Tradebook - 1
Citadel 2
Citigroup 4
Credit Suisse 4
Deutsche Bank 1
ETrade 2
Fidelity 1
Goldman Sachs 1
Interactive Brokers 3
JP Morgan Chase 2
Knight Capital 2
La Branch Co 1
Lehman Brothers 2
Merrill Lynch 2
Morgan Stanley 3
Nomura Holdings 1
Sun Trading 1
Susquehanna 1
UBS 2
Van Der Moolen 2
Total investments / owned 4 / 42 10 / 49 4 / 40 4 / 45 6 / 50 6 / 89
27
Order flow to sales desk continues to decline as
traders direct more flow to echannels
Shares by execution venue (share weighted)
2 Year CAGR
Source TABB Group Institutional Equity Trading
2006 Preliminary
28
A convergence of events forcing exchanges to look
outside of themselves

• Exchanges are going public
• Forces these organizations to
• Be more efficient
• Grow revenues 10 to 20 annually
• Cant do that, trading the same old products
• Crossing networks are expanding significantly
• Liquidnet has hit 60 million shares per day and
  Pipeline over 25million
• Internal crossing
• Brokers matching order flow internally
• Market share stats
• NYSE loosing almost 1 market share per month
  dropping from 90 in 04 to less than 63 Sept
  06 (including Arca volumes)

29
Reg NMS, economics, and technologies are poised
to change exchange economics

• Incentives set up for NYSE / NASDAQ to lose share
• Top of book protection incents more market
  centers
• 6 protected orders are better than 2
• Market data rebate changes allows exchanges to
  rebate tape revenues
• Greater tape rebates by regionals will incent
  brokers to put limit orders in regionals
• Routing engines work from fastest to slowest
• High speed exchanges trade at 5 to 10
  milliseconds
• Hybrid project to be 500 milliseconds
• Routing engine can ping Inet 100times before NYSE
  responds
• If limit orders move to edge and routing engines
  execute from edge in
• Fewer shares in center
• Liquidity will even out
• NYSE NASD will lose share
• That is why LSE / Euronext is vitally important
  !!!!

30
Because of this, US market centers are in global
expansion mode

• Elephant dance
• NASDAQ acquired 25 of LSE
• NASDAQ has veto ability to kill any acquisition
  deal
• NYSE for Euronext
• Challenged by Deutsche Bourse
• Price expected to escalate
• Both exchanges paying top dollar
• Other activity
• Significant investment in new equity exchanges in
  US a little in UK
• New Equity Exchanges
• ISE, Phila, Boston, CBOT, Plus Markets (UK)
• Moves to develop derivatives exchanges
• New Options Exchanges
• NYSE/Pacific, NASDAQ

31
Europe is the next battle ground because

• European markets are basically still a monopoly
• Little inter-market competition
• Sarbanes Oxley forces firms to list overseas
• NYSE / NASDAQ need marquee names
• Out of the IPO gate they need a big name
• Asia is too far away to make a big splash except
  for Tokyo
• Japanese will not give up the TSE no way
• LSE Euronext are the marquee brands
• Euronext has many valuable pieces
• Euronext Liffe 3rd largest derivatives exchange
• MTS Largest sovereign debt electronic trading
  platform outside of US
• LCH Clearnet London Pan-European securities
  depository (45.1 interest)
• Paris, Brussels, Lisbon, Copenhagen Stock
  Exchanges
• GL Trade provider of order management software
• Joint venture with Atos to sell and implement
  exchange technology and provide general trading
  technology integration services
• LSE is the largest European stock exchange

32
LSE/Euronext are however very expensive
Euronext LSE 1 year performance

• Euronext / LSE performance 60 to 100 over last
  12months
• Acquirers performance weaker than targets
• Deutsche Boerse up 40 NYSE performance up 20
• Nasdaq down 20
• NASDAQ acquired 25.1 making it difficult for NYX
• NYSE being out flanked by Greifield and NASD
• NYSE turn sites to Euronext
• Significant questions on whether Regulators and
  Politicians will let this happen at all

NYX, Nasdaq Deutsche Boerse 1 yr performance
33
Darkpools
34
Dark pools crossing networks match order flow
on its way to the exchange
Proprietary
External Order Flow
Retail
Institutional
Market Making
Transient Flow
Dark Pool
Prime Broker
Resident Flow
Traditional AM
DMA
Algo
Phone
Matched
Unmatched
FIX
Executions
Market Centers
Source TABB Group
35
Dark pools change market structure from exchange
to OTC market

• Benefits
• Price improvement (generally mid-point pricing)
• Lower execution cost no exchange fees (only
  printing)
• Less market impact (no one see order)
• Larger executions (average print lt 400 shares)
• Challenges
• No or less visibility
• Can be difficult to interact with order flow
• Less price discovery / competition

36
Dark pools crossing nets are fragmenting as at
least 29 are in or near production in US
Open
Intraday
Nasdaq
End of Day Cross
Merrill
Posit Now
Block Alert
Posit Match
ITG
Instinet
Intraday
End of Day
Continuous
VWAP Cross
Natural
Millennium
NYFIX
H20
Liquidnet
Liquidnet
Morgan
Lava
Lava ATS
Source TABB Group, Companies, Fidelity Capital
Markets
37
Fragmentation will increasing be the key industry
challenge
Buy-side trader most significant challenges

• Fragmentation
• 12 exchanges or significant ECNs
• 29 unlinked dark pools
• Countless algorithms
• Inability to do size
• Solutions are
• Crossing networks help but
• Too much of a good thing
• DMA/Aggregation technologies
• Cost of market data and infrastructure make
  development difficult
• Algorithms
• Cause further fragmentation

2005
Source TABB Group Institutional Equity Trading
in America 2005
38
There is a new business in developing dark
routing strategies

• CS, ITG, Instinet, Piper, Lava, and other have
  developed dark routers
• The challenge is
• Crossing logic
• Different for all dark pools
• Transient orders
• Taking liquidity is easier than placing
• Resident orders
• Need to be careful with resident orders
• Who is in the queue ahead of you?
• What happens to the order if there are multiple
  resident orders?
• Time Priority? Commission Priority? Broker
  Priority? Parity?

39
It about cost
40
The cash equity business is becoming about cost
Share Volume By Destination

• No and low touch trading comprises over 40 of
  share trading
• Price per share of low touch trades can get below
  .5cents per share
• Broker loss ratios getting increasing
• Exchanges are raising their prices

Source TABB Group Institutional Equity Trading
in America 2006
41
Commission pressure over past year has been
significant (especially in electronic channels)
Decrease 05 to 06
Average per share costs (pennies)
-4.0
-21.0
-10.0
-28.0
-38.0
Source TABB Group Institutional Equity Trading
2006 Preliminary
42
Thinning broker ranks

• Because of economics and regulation
• Brokers cant make significant money in cash
  equities
• Lose ratios up
• More volume going through low touch
• Research model is broken
• SEC pushing best execution
• Buy-side firms are conflicted between
• SEC Best execution obligations
• Fiduciaries looking for commission recapture
• Portfolio managers looking to pay research bills
• Changing dynamics
• Largest brokers will manage executions
• Medium brokers will be challenged
• Smaller brokers will become research houses paid
  by larger brokers

43
Buy-side clearing just smoke or is there heat?
Accounts/Portfolios
44
Conclusions

• Flat yields and lack of US Investment returns
  forcing funds to change investment strategies and
  mechanisms
• New markets, products, strategies and
  technologies
• As clients change, exchanges are changing as well
• Dealers dont want to be locked in so they are
  investing
• This is fragmenting the market, making it more
  difficult to trade settle
• Fragmentation pushes firms toward electronic
  solutions
• As trading becomes more electronic, efficiency
  and cost becomes much more important
• As cost becomes primary driver firms into more
  complex and lucrative products

45
Preparing for the Future An outline of
critical industry issues and emerging trends

• Presented by
• Larry Tabb
• Founder CEO
• TABB Group