Bank Depository User Group Tampa, FL October 15-16, 2006 “Preparing for the Future” An outline of critical industry issues and emerging trends Presented.

Bank Depository User GroupTampa, FL

October 15-16, 2006

“Preparing for the Future” An outline of critical industry issues

and emerging trends

Presented byLarry Tabb

Founder & CEOTABB 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

Net Issuance of Corporate Equities

-71.4 -69.8-64.0-45.7

72.3

99.6

12.81.5

14.7

-46.4

-113.3

1.5 5.3

98.3

46.3

119.1133.4

-102.6-106.6

34.5

-195.0-200

-150

-100

-50

0

50

100

150

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Source: Flow of Funds Accounts of the U.S., Board of Governors of the Federal Reserve SystemNote: Excludes mutual fund shares

$ billions

(e)

5

Foreign markets over the past 2 years have outperformed the US market

India

Korea

JapanDAX

CAC

FTSEHK

S&P 500

China

6

Derivatives business are all at record levelsOver-the-Counter Interest Rate Derivatives

Outstanding Notional Principal Amounts

57.31

82.74

101.32

123.90

183.58

201.41

220.00

164.49

142.31

69.21

0

25

50

75

100

125

150

175

200

225

250

1H 2H 1H 2H 1H 2H 1H 2H 1H 2H(f)

$ trillions

2001 2002 2003 2004 2005

Source: ISDA Mid-Year 2005 Market Survey, SIA forecastNote: Interest rate derivatives, for the purpose of this Survey, include interest rate sw aps and options and cross-

Over-the-Counter Credit DerivativesOutstanding Notional Amounts

2.19

18.00

5.44

8.42

12.43

1.56

0.63

2.69

3.78

0.92

0

2

4

6

8

10

12

14

16

18

20

1H 2H 1H 2H 1H 2H 1H 2H 1H 2H(f)

$ trillions

2001 2002 2003 2004 2005

Source: ISDA Mid-Year 2005 Market Survey, SIA forecastNote: Credit derivatives, for the purpose of the Survey, include credit default sw aps, baskets and portfolio transactions indexed to single names, indexes, baskets, and portfolios.Over-the-Counter Equity Derivatives

Outstanding Notional Amounts

2.32.5

3.4

4.2

5.4

3.8

2.8

4.8

0

1

2

3

4

5

6

1H 2H 1H 2H 1H 2H 1H 2H(f)

$ trillions

2002 2003 2004

Source: ISDA Mid-Year 2005 Market Survey, SIA forecastNote: Equity derivatives, for the purpose of this Survey, include equity sw aps, options and forw ards.

7

While mutual fund growth impressive, hedge fund AuM growth has not escaped notice

$0.1

$11.9 $11.7 $11.3

$14.0

$16.2

$17.8

$0.1 $0.1 $0.6 $1.0 $1.2

2000 2001 2002 2003 2004 2005

Hedge Funds Mutual Funds

8.4%

76.5%

MutualFunds

HedgeFunds

AuM growth of Hedge Funds vs. Mutual Funds (in $US trillions)

Hedge Funds vs. Mutual Funds AuM CAGRs

Long Only Value Model

.75 to 1.5% AuM

Hedge Fund Value Model

1% to 2% AuM plus

10% to 20% of profitsSource: 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

54%

40%

35%

Large

Medium

Small

Institutional managers launching hedge funds (2006)

No83%

Yes17%

Institutional managers planning on launching hedge funds by ‘08

Source: TABB Group “Institutional Equity Trading 2006 – Preliminary

10

Who are your investors ?

HFs inflows are becoming more institutional

2 Year Change

2%

1%

16%

2%

3%

7%

10%

91%

63%

47%

45%

41%

32%

17%

93%

64%

63%

47%

44%

38%

27%

Individuals

FoF

Institutions

Trusts

Endowments

Corporate Pension Plan

Public Pension Plan

2006 2008Source: 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

63%

36%

59%

Small

Medium

Large

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

What Changes Were Made?

The bulk of hedge funds are adding strategies and looking globally for alpha

11%

11%

26%

11%

26%

42%

9%

11%

16%

25%

34%

39%

Concentrated Portfolio Base

Change in Focus

Additional Asset Classes /Weighting

Improve Core Product

Added A New Strategy

Expanded Globally

Large TotalSource: TABB Group study “Hedge Funds 2006: The Quest for Alpha in an Increasingly Competitive World

13

22%

20%

16%

14%

14%

6%

8%

34%

29%

15%

32%

17%

2%

37%

15%

Global

Equities

Europe

Asia

Other

Private Equity

Fixed Income

Undecided

Last Two Years Next Two Years

Additional Geographies and Asset Classes: Past and Present

12%

9%

-1%

18%

3%

-4%

27%

15%

Funds are investing abroad and looking at other kinds of asset classes

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 => Knight OnTrade (NexTrade’s ECN) =>Citi 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

Money Management Soft Dollar Trends

Greater number of large firms banning soft dollars

Source: TABB Group Institutional Equity Trading 2005

Down None Stable Up

47%

70%

40%

20%

7%7%10%

33%

17%

17%

7%

33%

47%

13%

33%

36%

25%

18%

21%

26%

26%

30%

17%

SmallMedium'05

Large'04 '05'04 '05'04

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

InstinetArca

Brut

From whence we come

Island

Attain

Strike

TradeBook

Redi

NextTrade

Arca

BATS

Brut

NASDAQ Knight

Citi

NYSE

Instinet

NASDAQ

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

E*Trade – 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 e*channelsShares 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 Can’t 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 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

Euronext & LSE 1 year performance

33

Darkpools

34

Dark pools & crossing networks match order flow on its way to the exchange

Retail

DMA

Algo

Phone

FIX

Prime Broker

Traditional AM

InstitutionalMarket Making

Proprietary

ResidentFlow

Tra

nsie

nt F

low Dark

Pool

Executions

Matched

MarketCenters

Unmatched

ExternalOrder Flow

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 < 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

Citigroup, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley,UBS

BIDS LeveL

Citigroup, Lehman Brothers, Merrill Lynch, Credit Suisse ,Fidelity Brokerage

Posit Now Block Alert MerrillPosit MatchITG

NYFIX

Open IntradayEnd of Day CrossNasdaq

MatchPointNYSE

NaturalMillenniumH20LiquidnetLiquidnet

PipelinePipeline

Cross FinderCredit Suisse

Sigma XGoldmanLava ATSLava

PINUBSACECitiGroup

Citadel Ex SvsCitadel

PoolMorgan

Intraday End of Day Continuous VWAP CrossInstinet

Opening CrossArca

Lehman ATSLehmanLiquidity PingATDKnight MatchKnight

Source: TABB Group, Companies, Fidelity Capital MarketsLatticeState Street

37

Fragmentation will increasing be the key industry challenge 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

9%Market

Structure

83%Liquidity /Fragmentation

9%Lack of

Transparency

8%Algo Overload

8%Cost

4%Regulatory

Environment

25%Trade Size

2005

Buy-side trader most significant challenges

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 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

Share Volume By Destination

Source: TABB Group – Institutional Equity Trading in America 2006

41

Commission pressure over past year has been significant (especially in electronic channels)

Average per share costs (pennies) % Decrease ’05 to ‘06

-4.0%

-21.0%

-10.0%

Source: TABB Group “Institutional Equity Trading 2006 – Preliminary

-28.0%

-38.0%

42

Thinning broker ranks

Because of economics and regulation Brokers can’t 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

400,000

Trading desk

100,000

100,000

100,000

100,000

BrokerExecutions 10

10

10

10

Allocations

40Custodian

Accounts/Portfolios

400,000

Trading desk

100,000

100,000

100,000

100,000

BrokerExecutions

10

10

10

10

Allocations

Aggregation 10

Custodian

10

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 don’t 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

Bank Depository User GroupTampa, FL

October 15-16, 2006

“Preparing for the Future” An outline of critical industry issues

and emerging trends

Presented byLarry Tabb

Founder & CEOTABB Group