Aite-Alt Execution Sep2006

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Actionable, strategic advice on IT, business, and regulatory issues in the financial services industry
THE U.S. EQUITIES MARKET IN TRANSITION: ALTERNATIVE EXECUTION VENUES
INTRODUCTION
Competition and fragmentation are two words that can be used to aptly describe the current state of affairs in the U.S. exchange market. While the two largest pools of liquidity continue to seek global dominance, the domestic U.S. equities market remains largely fragmented, at least on the surface. However, it would be a mistake to equate increasing competition with market fragmentation. When examined closely, the U.S. equities market is still dominated by the New York Stock Exchange (NYSE) and NASDAQ. According to an Aite Group analysis, as of Q2 2006, the NYSE Group and NASDAQ collectively account for 78% of the entire U.S. equities market (see Figure 1 on page 1). By Aite Groups estimation, there are over 20 other execution venues that are battling for the remaining 22% of the U.S. equities market share.
FIGURE 1: U.S. EQUITIES MARKET SHARE -- Q2 2006
U.S. Equities Market Share Broker Internalization 13% ATSs 4% ECNs 3% Regional Exchanges 2%
NYSE Group 47%
NASDAQ 31%
Exchanges, ECNs, ATSs, Brokers, Aite Group estimates
Sang Lee 617.338.6015 slee@aitegroup.com
IMPACT NOTE
10 High Street Suite 905 Boston, MA 02110 Tel: 617.338.6050 Fax: 617.338.6078 info@aitegroup.com
Alternative Execution Venues
SEPTEMBER 2006
This Impact Note examines the key alternative execution venues in the U.S. equities market and will analyze their future prospects over the next few years.
MARKET STRUCTURE EVOLUTION

The U.S. equities market structure has undergone major changes over the last decade. In the aftermath of the Order Handling Rules (OHR) of 1997, competition increased substantially and lead to the creation of various independent execution venues including ECNs and private ATSs. Market fragmentation appeared to be the norm, at least in NASDAQ, as various viable execution venues emerged to seriously threaten NASDAQ for execution revenues.
FIGURE 2: TIMELINE OF U.S. EQUITIES EXECUTION VENUES
Launch of Liquidnet Launch of NASDAQ SuperMontage NYSE launches Direct+ Launch of Instinet 1969 1997 1998 1999 2000 2001 2002 2003 2004 2005 NYSE acquisition of ArcaEx and NASDAQ acquisition of INET
Citigroup acquires OnTrade ECN from NexTrade
1987: Launch of ITG POSIT
Knight acquires Attain and renames it Direct Edge ECN
2006
Order Handling Rules (OHR) approved. Launch of Island, Archipelago, and REDIBook
BRUT/Strike merger Archipelago and Pacific Stock Exchange to launch electronic stock exchange Archipelago/REDIBook merger Feb 1998: Launch of Attain Nov 1998: Launch of NexTrade and Strike Technologies Late 1998: Launch of Bloomberg TradeBook
Instinet/Island merger Launch of Track ECN
Launch of BATS ECN NASDAQ acquisition of BRUT Launch of Pipeline
Source: ECNs, Aite Group
However, by 2002, a wave of consolidation began that was triggered by the merger between Archipelago and REDIBook (owned, at that time, by Goldman Sachs). The most significant ECN merger occurred when Instinet acquired Island (forming INET), its chief competitor in the ECN market. NASDAQ went on a spending spree soon after that and was determined to recapture its lost market share by acquiring
2006 Aite Group, LLC. All rights reserved. Reproduction of this report by any means is strictly probihited.
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BRUT. This consolidation trend hit its peak when the NYSE acquired ArcaEx and when NASDAQ teamed up with INET, thereby creating a de facto duopoly in the U.S. equities market. The conception and passage of Regulation NMS has also played a key role in recent market developments as new and incumbent execution venues look for opportunities in the post-Reg NMS market structure. The end result of all these M&A activities was that in a short span of time, all of the large ECNs had disappeared and had left the ECN market littered with smaller players. Perhaps more importantly, the NYSE and NASDAQ forcefully moved back to the top of the execution market (see Figure 3 on page 3).
FIGURE 3: MARKET CONSOLIDATION
Order Handling Rules of 1997 Implemented 1997 1998 2000 2002 2004 2006
Instinet Island BRUT Strike Archipelago REDIBook Bloomberg TradeBook Attain Acquired by Knight and renamed Direct Edge ECN NexTrade Acquired by Citigroup Track ECN BATS
Source: ECNs, NASDAQ, NYSE Group, Aite Group
Merger with Instinet, renamed INET NASDAQ NASDAQ Merger with BRUT Acquired by NASDAQ
Acquired by NASDAQ
NYSE NYSE Merger with Archipelago Acquired by NYSE
Going against this industry trend of consolidation has been the acceleration of market fragmentation, at least on the surface. Since 2002, a number of ATSs, led by Liquidnet, have emerged to meet the growing need for block trading in the marketplace. Fearful of total dominance by the NYSE and NASDAQ, large dealers and a number of buy-side firms have formed partnerships to either support existing regional exchanges or to create new execution venues. Large bulge
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bracket firms have also jumped into the fray by either launching or developing internal crossing engines designed to take advantage of the massive order flow going through their trading desks.
ELECTRONIC COMMUNICATION NETWORKS (ECNS)

Over the past nine very competitive years, ECNs have played a key role in fundamentally changing the competitive landscape in the U.S. equities market, especially in trading NASDAQ stocks. With the acquisition of all of the major ECNs by leading exchanges, however, it is highly questionable how some of the remaining ECNs will actually perform in the post-Reg NMS market structure.
TABLE A: ECNS LEFT STANDING
ECN Bloomberg TradeBook Direct Edge (formerly Attain)* OnTrade BATS Track ECN Launch Date Late 1998 February 1998 Ownership Bloomberg Knight Trading Average Daily Trade Volume 150 million 70 million
November 1999 January 2006 April 2002
Citigroup Tradebot Systems, etc. Track Data Corporation
1.5 million 7.9 million 11.9 million
Source: ECNs, Aite Group estimates *Includes both matching and routing
The only ECNs with formidable liquidity are Bloomberg TradeBook (which has expanded its focus into other asset classes, including futures and FX) and Direct Edge ECN (see Figure 4 on page 5). Despite the odds, a new ECN called the Better Alternative Trading System (BATS) launched on January 2006. Overall, ECNs currently account for 6% of the entire U.S. equities market (see Figure 5 on page 5).
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FIGURE 4: ECN MARKET SHARE ANALYSIS
ECN Market Share OnTrade 1% BATS 3%
Track ECN 5%
Direct Edge 29% Bloomberg TradeBook 62%
Source: ECNs
FIGURE 5: ECNS MARKET SHARE IN THE U.S. EQUITIES MARKET
% of ECN Market Share in U.S. Equities Market Q2 2006 ECNs 6%
U.S. Equities Market 96%
Source: ECNs, NYSE, NASDAQ, Aite Group estimates
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B AT S T R A D I N G
Launched in January 2006 and headquartered in Kansas City, MO, BATS is the newest entrant in the ECN market. BATS is a spin-off from Tradebot Systems, one of the leading automated liquidity providers in the U.S. equities market. BATS' other investors include GETCO and Wedbush. BATS currently has about 20 employees. In the second quarter of 2006, BATS was the first ECN to make the switch from Nasdaq SuperMontage to NSX. This initially caused their volumes to drop, but this switch positions BATS well, relative to other ECNs, when SuperMontage becomes unavailable this fall. BATS' volume has been steadily climbing since they completed the migration to NSX and changed pricing on July 1, 2006. BATS volume reached a peak of 43 million shares on August 28, 2006 (see Figure 6 on page 6).
FIGURE 6: AVERAGE DAILY TRADE VOLUME PROGRESS OF BATS
BATS Average Daily Trade Volum e 35,000,000 30,000,000 25,000,000 20,000,000 15,000,000 10,000,000 5,000,000 0 4/7/2006 5/5/2006 1/27/2006 2/10/2006 2/24/2006 3/10/2006 3/24/2006 4/21/2006 5/19/2006 6/2/2006 6/16/2006 6/30/2006 7/14/2006 7/28/2006 8/11/2006
Source: BATS
BATS currently has about 60 subscribers, a number which has been growing between 5 and 10 per month. While BATS is only open to the sell-side, buy-side firms can have access to BATS via sponsorship from their brokers. BATS has been averaging about 500 shares in executed trade size. Some of the key data on BATS include the following:
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Has a highly competitive pricing schedule and charges US$.0027 per share for liquidity takers and offers a rebate of US$.0025 per share for liquidity providers; Focuses on technology developed in-house along with handson customer service, Various connectivity options including point-to-point, VPN, third-party extranets, etc.; Quoting and printing trades on NSX (National Stock Exchange); Support for reserve and discretionary order types; The BATS Conditional Order type is not available in other markets; Support for FIX, POUCH (for order entry), and PITCH (market data distribution); and Runs on Linux with HP Blade Servers and utilizes a storage area network built by EMC.
FIGURE 7: SCREENSHOT OF BATS
Source: BATS
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Although entering a hyper competitive marketplace, BATS has managed to gain a respectable market share in a short period of time. The liquidity provided by Tradebot, Getco, and other quantitative liquidity providers has no doubt given BATS an advantage among the newer market centers. BATS' competitive pricing schedule has also played a key role in its market acceptance to date. In order to increase its market presence, however, BATS will have to demonstrate that it can attract more liquidity removers.
DIRECT EDGE ECN

Launched in 1998 and formerly known as Attain (founded by All-Tech Investment Group), Direct Edge ECN has been re-energized thanks to the acquisition by Knight Capital Group in Q2 2005. Re-branded as Direct Edge ECN, it has experienced significant volume growth in recent quarters and averages 70 million shares a day as of August 2006 (see Figure 8 on page 8). More than half of that volume is being matched internally within Direct Edge (see Figure 9 on page 9). This places Direct Edge right behind Bloomberg Tradebook in terms of overall market share in the ECN market. Headquartered in Jersey City, NJ, there are currently 15 employees fully dedicated to Direct Edge ECN with 15 more resources available from the Knight infrastructure group.
FIGURE 8: AVERAGE DAILY SHARE VOLUME OF DIRECT EDGE ECN
Number of Shares 90,000,000 80,000,000 70,000,000 60,000,000 50,000,000 40,000,000 30,000,000 20,000,000 10,000,000 0 3/1/2006
Direct Edge Average Daily Trade Volum e
6/7/2006
7/5/2006
3/15/2006
3/29/2006
4/12/2006
4/26/2006
5/10/2006
5/24/2006
6/21/2006
Source: Direct Edge ECN
7/19/2006
8/2/2006
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FIGURE 9: BREAKDOWN OF DIRECT EDGE ECN VOLUME
Details Behind Direct Edge ECN Trade Volum e
Routed Out 45% Internal Match 55%
Average Daily Trade Volum e = 70 m illion shares
Source: Direct Edge ECN
Currently, Direct Edge displays its orders on both the Alternative Display Facility (ADF) and SuperMontage under the market participant identifiers (MPIDs) EDGA for ADF and EDGX for SuperMontage. However, as NASDAQ migrates over to the INET platform, EDGX will also be migrating over to ADF. Key Direct Edge information includes the following: Looking to provide enhanced liquidity with high levels of fill rate at competitive pricing; Open to broker-dealers; Ability to trade NASDAQ National Market and Small Cap stocks; Submission of orders through Direct Edge Portal which integrates client OMS with Direct Edge ECN; Direct Edge View enabling depth-of-book look into Direct Edge ECN; Three display options: fully display, reserve, and hidden; and Competitive pricing schedule: charging US$.003 per share for liquidity takers and offering rebate of US$.0022 per share for liquidity providers.
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Prior to the acquisition by Knight Capital Group, Direct Edge ECN (at that time known as Attain) was one of the smallest ECNs in the marketplace. With the backing of Knight, however, Direct Edge has jumped into the leadership position and is continuously growing its market share. Future projects include moving into the listed market, introducing sophisticated order types to tap into dark pools of liquidity, and potentially providing algorithms to better access the ECN.
B L O C K TR A D I N G N E T W O R K S
Unlike the ECNs which seem to be disappearing from the competitive landscape, the popularity of ATSs appears to be only increasing, especially for those platforms serving the block trading market.
TABLE B: BLOCK TRADING PLATFORMS
Platform ITG POSIT Liquidnet 1987 2001 Launch Date ITG Privately owned with private equity funding from TH Lee Putnam Ventures, Summit Partners, and Technology Crossover Ventures. Pipeline NYFIX Ownership Average Trade Size 23,000 48,000
Pipeline NYFIX Millennium
2004 2001
42,000 600
Source: Firms, Aite Group estimates
ITG POSIT
Founded in 1987 as a subsidiary of Jefferies & Co. and headquartered in New York, Investment Technology Group (ITG) is a technology-driven agency broker that was initially made famous for POSIT (its equities private crossing network) and QuantEX (the industry's first trading platform to support quantitative trading, which launched in 1991). As the clear pioneer in the marketplace, ITG gained a strong following from the buy-side quant traders during the 1990s. ITG has nurtured an entire generation of technologists and quantitative analysts who are leading Wall Street's push towards the adoption of advanced trading services. ITG currently has 1,015 employees worldwide with operations in the United States, Canada, Europe, Australia, Hong Kong, and Japan. ITG's strength has always been its reliance on technology to attract and manage clients. ITG's recent flurry of acquisitions and growth followed years of uncertainty and doubt during the early 2000s. Rumors were rampant of their imminent acquisition by larger brokers as their market share continued to decline in both
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their trading front-ends and POSIT. The emergence of new, more nimble and lower-cost providers appeared to spell their eventual doom. However, the re-birth of ITG occurred quite swiftly. With the introduction of Triton, ITG aggressively moved to replace QuantEX, its popular but outdated trading platform. ITG also went on an acquisition spree by purchasing Macgregor, a leading buy-side OMS provider, as well as Plexus, a leading TCA service provider. Through internal development and acquisitions over the last couple of years, ITG has created a suite of products and services that are capable of supporting the entire trade life-cycle -- from pre-trade and trade to post-trade analysis.
FIGURE 10: BREAKDOWN OF ITG PRODUCTS AND SERVICES
Pre-Trade Analytics ITG Logic
Trade & Execution POSIT
Post-Trade Analysis TCA Fair Value Model Plexus
ITG/Opt
Triton
ITG eXtra
Radical
Plexus
Macgregor XIP
ITG Algorithms ITG Trading Services ITG Hoenig

Source: ITG
For the purpose of this report, only POSIT will be examined. POSIT falls under ITG's Trade & Execution Services. Launched nearly 20 years ago, POSIT is the oldest crossing platform in the marketplace. As of Q2 2006, POSIT averaged approximately 46 million shares a day with an average trade size of 23,000 shares (see Figure 11 on page 12). POSIT has increased its trade volume significantly over the last few quarters after a brief decline that began in late 2003. Currently, ITG has three flavors of POSIT:
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FIGURE 11: AVERAGE DAILY SHARE VOLUME
Mns of Shares 50 45 40 35 30 25 20 15 10 5 0
30 3 Q Q Q Q
POSIT's Average Daily Share Volum e
% of Market Share 80% 70% 60% 50% 40% 30% 20% 10% 0%
20 4
Average Daily Share Volume

Source: ITG, Aite Group estimates
% of Market Share
POSIT Match. Launched in 1987, POSIT Match is ITG's classic scheduled crossing service that provides anonymous, mid-point matching with zero market impact. POSIT Match is open to both the sell-side and the buy-side. POSIT Now. Launched in 2001, POSIT Now is a continuous crossing service (every 30 seconds) which currently accounts for the fastest growth rate. POSIT Now is open to both the sell-side and the buy-side. Block Alert. Originally launched in Q3 2005 as POSIT Alert, Block Alert is a Liquidnet-type crossing mechanism where blotters of OMSs are tied together to seek active crossing opportunities. Block Alert sits outside of the passive matching POSIT network and invites users to participate. There is no negotiation process in Block Alert to ensure that all order information is anonymous. POSIT Alert was re-branded in the first quarter of 2006 as Block Alert as part of a joint venture with Merrill Lynch that paired Merrill Lynch's liquidity with ITG's crossing technology. Block Alert requires users to adhere to a minimum trade size based on the average daily trade volume: - Large-cap: 25,000 shares;
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- Mid-cap: 5,000 shares; and - Small-cap: 1,000 shares. Users can access POSIT liquidity by utilizing Channel ITG, a trading tool. Once Channel ITG is integrated with an OMS, it can automatically sweep the OMS blotter and send out orders to multiple ITG execution venues. Channel ITG is currently integrated with Macgregor, Eze Castle, and Charles River. Users can also access POSIT using ITG's two trading front-ends or a direct FIX connection: Triton. This is ITG's flagship portfolio-trading application which has replaced QuantEX. Triton provides full list and order management for portfolio trading with a complete audit trail. Radical. This is ITG's Windows-based EMS platform for single-stock trading. Similar to Triton, Radical is brokerneutral and has access to all major execution venues as well as broker algorithms.
POSIT continues to look for additional market opportunities outside of the U.S. market. Indeed, POSIT has become a global offering with its presence in Europe, Canada, Australia, and Japan.
LIQUIDNET
Launched in 2001 with 38 buy-side members, Liquidnet is the current market leader in block trading platforms. Liquidnet came out of nowhere in 2001 to compete against ITG's POSIT service and ultimately became the largest block trading network in 2004. Liquidnet is headquartered in New York and currently has 185 employees. Liquidnet started out as a buy-side-only network with a very simple concept -- to enable buy-side to buy-side block trading without broker involvement. The key to Liquidnet's initial success was its ability to link up with all of the major buy-side OMS vendors. The Liquidnet platform essentially sweeps the trade blotters of its members, and when there is a natural execution to be made, it alerts both parties, and only those parties, so they can begin negotiating. Liquidnet's timing could not have been better than at the time of its launch, as the institutional market was struggling to find a large size in the public market without causing market impact. Not surprisingly, Liquidnet's simple concept caught on quickly, and it enabled Liquidnet to eventually attract an impressive US$250 million investment from Summit Partners and Technology Crossover Ventures during Q1 2005. Continuing to build on its success, Liquidnet had 341 members as of Q2 2006; a majority of these members (85%) are from North America (see Figure 12 on
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page 14). Liquidnet's average daily trade volume has also skyrocketed, averaging 45 million shares per day during Q2 2006 and a high of nearly 76 million shares in July. Liquidnet's current volume accounts for approximately 36% of the block trading network market (see Figure 13 on page 14).
FIGURE 12: LIQUIDNETS MEMBERSHIP BREAKDOWN
Liquidnet Mem bership Europe 14%
North America 86% Total Num ber of Mem bers = 341 (as of Q2 2006)
Source: Liquidnet
FIGURE 13: AVERAGE DAILY SHARE VOLUME AND GROWING MARKET SHARE
Mns of Shares 50 45 40 35 30 25 20 15 10 5 0
Liquinet's Average Daily Share Volum e
% of Market Share 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
40 3
40 4
10 6
40 2
10 3
20 3
10 4
20 4
30 4
10 5
20 5
30 5

Source: Liquidnet, Aite Group estimates
% of Market Share
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30 3
40 5
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The bulk of Liquidnet's business is done with the mid-cap and large-cap stocks; combined, they account for 80% of all shares traded and over 70% in total execution (see Figure 14 on page 15). Meanwhile, small- and micro-cap names
account for 27% of the firms executions, yet they tend to dominate the block volume in those names. Approximately one out of every three small- and micro-cap names that are executed in Liquidnet represent 100% of the block trading volume in that name for the day. Liquidnet has also done quite well on the NYSE-listed stocks which account for 61% of total shares traded and 57% of total execution (see Figure 15 on page 15). FIGURE 14: LIQUIDNET STATISTICS BASED ON MARKET CAP
Liquidnet Perform ance Based on Market Cap 60% 50% 40% 30% 20% 10% 0% Large Cap Mid Cap Small Cap Micro Cap 32% 21% 17% 3% 4% 23% 48% 52%
% of Shares Traded
Source: Liquidnet
% of Executions
FIGURE 15: LIQUIDNET STATISTICS BASED ON EXCHANGE
Liquidnet Perform ance Based on Exchange 70% 60% 50% 40% 30% 20% 10% 0% NYSE % of Shares Traded NASDAQ % of Executions 38% 61%
57% 42%
Source: Liquidnet
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In 2002, Liquidnet launched its European initiatives from the UK. Liquidnet has expanded its European coverage over the last couple of years and currently includes the UK, France, Germany, Italy, the Netherlands, Switzerland, Belgium, Denmark, Finland, Norway, Sweden, Portugal, Iceland and Luxembourg. Liquidnet Europe Limited has quickly grown to be ranked among the largest agency brokers on the London Stock Exchange (LSE), breaking into the top 10 this summer as the ninth largest broker. Figure 16 on page 16 illustrates Liquidnets growing presence in the European block trading market.
FIGURE 16: LIQUIDNET IN EUROPE
Mns of GBP 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 H1 2003 H2 2003 484 1,102
Total Principal Traded 8,262
5,023
3,158 1,492 1,955
H1 2004
H2 2004
H1 2005
2H 2005
1H 2006
Source: Liquidnet
In recent months, Liquidnet has introduced H20, which is designed to position the large buy-side liquidity of Liquidnet to absorb smaller retail as well as algorithmic flow coming from various ECNs, exchanges and sell-side streaming liquidity providers including Bloomberg TradeBook, BNY Brokerage, Instinet, FutureTrade, Miletus Trading, Piper Jaffray, EdgeTrade, UNX, Goldman Sachs Execution & Clearing (GSEC), Lehman Brothers and Credit Suisse. Not content with its initial success in the U.S. equities market, Liquidnet continues to seek global opportunities. During Q2 2006, Liquidnet opened its Hong Kong and Tokyo offices with expectations of opening up another office in Australia before the end of 2006. The goal is to launch its services in the Asian market during the first half of 2007. Liquidnet also received approval from the Ontario Securities Commission (OSC) to trade Canadian equities starting in Q4 2006.
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N YF I X M I L L E N N I U M
Founded in 1991 and headquartered at 100 Wall Street in NYC, NYFIX provides an extensive list of technology and execution services for both the buy-side and the sell-side. Although known more as a technology provider, NYFIX is actually a fullservice agency broker that provides products and services from order inception to clearing. NYFIX has three broad service areas: FIX Products Division: FIX engines (Javelin and Appia), Tradescope (FIX monitoring), Indications of Interest/ Advertised Trade products, eQ (Realtime Trade Execution Quality Monitor) and the NYFIX Network (FIX Network); Order Management System (OMS) Division: FIXTrader, Renaissance, Fusion (an integrated version of FIXTrader and Renaissance), FloorReport (floor-based booth support system), and handhelds; and Brokerage Division: NYFIX Transaction Services (algorithmic trading solutions and domestic & international DMA), NYFIX Millennium (Alternative Trading System), NYFIX Clearing, etc.
While NYFIX is famous for its FIX-related products/services (e.g., FIX engine, FIX network, etc.) as well as its presence in the order management systems market, NYFIX Millennium, its anonymous crossing network, will be the focus for this report. NYFIX currently has 260 employees. NYFIX Millennium launched in 2001, three days before the September 11 tragedy. Not surprisingly, NYFIX Millennium struggled to get traction during 2001 and had to regroup in the middle of 2002. NYFIX experienced up and down growth during the next few years, but in 2005, the firm experienced a substantial growth spurt as it was able to attract increasing order flow from algorithmic trading strategies aimed at tapping into dark pools of liquidity. As of Q2 2006, NYFIX Millennium has been averaging a bit over 21 million shares a day, which represents approximately 16% of the block trading market (Figure 17 on page 18).
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FIGURE 17: NYFIXS AVERAGE DAILY SHARE VOLUME AND MARKET SHARE
Mns of Shares 25 20 15 10 5 0
NYFIX's Average Daily Share Volum e
% of Market Share 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0%
10 4
40 4
30 5

Source: NYFIX, Aite Group estimates
% of Market Share
NYFIX Millennium, which is a sell-side-only network (providing buy-side access via sell-side brokers or directly via NYFIX Transaction Services), attracts various types of orders, including retail flow (over 150 streaming retail providers), institutional trading desks, directed buy-side flow, conditional orders from agency desks, and hedge fund flow. NYFIX Millennium is a real-time, anonymous, continuously matching platform with the potential for price improvement. NYFIX Millennium is technically not a block trading network, as its average trade size is only 600 shares (which is still larger than the average trade size in the public market). In order to bring in a maximum level of liquidity, NYFIX has maintained a broker-neutral, vendor-neutral, and network-neutral policy. NYFIX has integrated Millennium into about 40 OMSs. In late 2005, building on its success of Millennium, NYFIX launched Millennium Natural, its buy-side-only service (including large hedge funds) that targets block trading. There are currently 75 buy-side firms involved in Millennium Natural. There are minimum order size requirements of 25,000 shares for Dow component stocks, 10,000 shares for S&P component stocks, and 5,000 shares for non-S&P component stocks to generate a NYFIX Natural IOI to stimulate block order interactions amongst the buy-side clients.
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P I P E L I N E TR A D I N G S Y S T E M S
Launched in September 2004, Pipeline Trading Systems is the newest entrant in the block trading game. However, the origin of Pipeline goes all the way back to 1999, and its management team has a wealth of experience in dealing with electronic markets. For example, Pipeline (as a subsidiary of e-Xchange Advantage) was involved in developing the Liquidity Tracker (designed to facilitate block trading among dealers) which functioned briefly within NASADQ in 2002. Pipeline also built BlockLink for Instinet, a block trading platform, which never launched due to Instinets merger with Island. Pipeline is headquartered in New York and currently has over 50 employees. The third time has indeed been a charm for the management of Pipeline as despite existing stiff competition from Liquidnet and POSIT, Pipeline has quickly gained a large following in the marketplace. Pipeline currently averages over 17.2 million shares a day and represents over 13% in total market share (as of Q2 2006). As an isolated number, Pipelines growth over the last few quarters has been impressive. What is more telling is that when one compares these numbers to industry leader Liquidnets numbers, Pipeline was able to reach the 10 million shares-per-day milestone in only six quarters, whereas Liquidnet took 10 quarters to achieve a similar feat.
FIGURE 18: PIPELINES AVERAGE DAILY SHARE VOLUME AND MARKET SHARE
Mns of Shares 20 18 16 14 12 10 8 6 4 2 0 Q304
Pipeline's Average Daily Share Volum e
% of Market Share 16% 14% 12% 10% 8% 6% 4% 2% 0%
Q404
Q105
Q205
Q305
Q405
Q106
Q206

Source: Pipeline, Aite Group estimates
% of Market Share
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Pipeline supports a completely open community with both buy-side and sell-side participation. Pipeline currently has 367 participants with a good mixture of both buy-side and sell-side firms (see Figure 19 on page 20).
FIGURE 19: PIPELINE COMMUNITY BREAKDOWN
Pipeline Com m unity Breakdow n
Sell-side 32%
Buy-side 68%
Total Num ber of Firm s = 367

Source: Pipeline
Pipelines Block Board is a simple thin-client application that provides a real-time view into Pipelines liquidity. The key to Pipelines success is the way the system is designed to discourage gaming behavior. Some of the key features of Pipeline include the following:
FIGURE 20: SCREENSHOT OF PIPELINES BLOCK BOARD
Source: Pipeline
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No local installation is necessary, and the client interface can be downloaded from the Web; FIX destination of most OMSs; A minimum amount of information is revealed (name of stock, indication there is a large size out there, no indication of whether buy or sell, etc.); There are minimum size requirements based on the average daily trading volume: 1) if the average daily trade volume exceeds five million shares = 100,000 shares minimum; 2) if the average daily trade volume is less than 500,000 shares = 10,000 shares minimum; and 3) all other stocks = 25,000 shares minimum; Immediate executions and no negotiations; and Aggressive orders are rewarded with a high percentage of price improvement on every execution.
Pipelines focus on facilitating block trading has paid off with its dramatic increase in overall liquidity over the last few quarters. Pipelines average trade size is also one of the highest in the marketplace with 42,000 shares.
B L O C K TR A D I N G C R O S S I N G N E T W O R K S E V A L U A T I O N
All averaging well above the public market size of less than 400 shares, the leading block trading ATSs have carved out a lucrative market within the institutional trading arena. Liquidnet currently leads in average daily trade volume with 46.2 million shares with an average trade size of 48,000. ITG is not too far behind with POSIT which has been averaging approximately 46 million shares with an average trade size of 23,000 shares. Pipeline, which is one of the newest entrants in this market, has built up quite a momentum over the last few months. It has increased its average daily trade volume from a mere 2.5 million at the end of 2004 to 17.2 million by the end of Q1 2006 (see Figure 21 on page 22). As a result, the block trading ATS market has become quite competitive in recent months. Liquidnet is holding onto its leadership position with 39% market share and is followed closely by ITG POSIT with 35% market share (see Figure 22 on page 22).
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FIGURE 21: AVERAGE DAILY TRADE VOLUME
Mns of Shares 140 120 100 80 60 40 20 0
Average Daily Trade Volum e
Q402 Q103 Q203 Q303 Q403 Q104 Q204 Q304 Q404 Q105 Q205 Q305 Q405 Q106 Q206 Liquidnet POSIT Pipeline NYFIX Millennium TOTAL
Source: Firms
FIGURE 22: BLOCK TRADING ATS MARKET SHARE Q1 2006
Block Trading ATS Market Share Q2 2006 NYFIX Millennium 16% Liquidnet 36% Pipeline 13%
POSIT 35%
Source: ITG, Liquidnet, NYFIX, Pipeline, Aite Group estimates
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In total, the average daily trade volume from block trading platforms has increased from 35 million shares per day in 2002 to 130 million shares per day at the end of Q2 2006. Despite their tremendous growth, block trading platforms account for only 3% of the entire U.S. equities market (see Figure 23 on page 23). As evidenced by their enormous growth over the last three years, the lack of penetration in the market also means that these block trading platforms hold tremendous growth potential, especially as the primary U.S. equities execution venues continue to face dwindling trade size and the threat of information leakage.
FIGURE 23: REALITY CHECK FOR BLOCK TRADING PLATFORMS
Mns of Shares 4500 4000 3500 3000 2500 2000 1500 1000 500 0 41.0
Reality Check on Block Trading Platform Grow th
% of Overall Market 4,093.0 4% 3% 3% 2%
3,083.9
3,258.0
3,467.7 2%
3%
2% 1%
2% 1%
51.7 2004
84.8 2005 U.S. Equities Market
130.4 Q206
1% 0%
2003 Block Trading ATS
% of Overall Market
Source: NASDAQ, NYSE, Liquidnet, ITG, Pipeline, NYFIX, Aite Group estimates
Page 23 of 29
SEPTEMBER 2006
SINGLE-BROKER CROSSING FACILITIES

In recent months, even individual brokers have joined the execution venue competition by launching internal crossing platforms designed to provide anonymous crossing for their client base. Depending on the firm, crossing could involve order flow from institutional clients, retail clients, algorithmic clients, as well as proprietary trading desks. Table C on page 24 provides a sample list of brokers and their internal crossing platforms.
TABLE C: SINGLE-BROKER INTERNAL CROSSING PLATFORMS
Broker Banc of America Securities Citigroup CSFB Goldman Sachs Instinet Launch Date 2004 2005 2004 2005 1998 Internal Crossing Platform Premier Block Trading Advanced Crossing Engine CrossFinder SIGMA X Intraday & End-of-day Crossing, CBX Institutional ECN Knight Match MS Pool PIN
Knight Capital Group Morgan Stanley UBS
2006 2005 2005
Source: Firms, Aite Group estimates
The concept of internalization is nothing new to these large brokers that have enough liquidity to provide anonymous crossing services prior to sending the client order flow to public markets and other execution venues. In fact, broker internalization currently accounts for 12% of all executions in the U.S. equities market (see Figure 24 on page 25). The difference now is that instead of manually providing internalization or internal crossing, firms are developing platforms to automate and centralize the process. From the brokers perspective, internal crossing provides cost savings in terms of eliminating exchange transaction fees. From the clients perspective, internal crossing can provide rapid, anonymous executions with minimum market impact. In order to succeed in driving adoption, however, brokers must be able to beat or at least meet the NBBO to provide greater chances of price improvement and to minimize the market impact. Without consistently meeting these two important requirements, further adoption of these dark pools of liquidity will be tough to achieve.
Page 24 of 29
SEPTEMBER 2006
FIGURE 24: MARKET SHARE OF BROKER INTERNALIZATION
% of Broker Internalization in U.S. Equities Market Q2 2006 Broker Internalization 12%
U.S. Equities Market 88%
Source: NASDAQ, NYSE, Aite Group estimates
DARK POOLS OF LIQUIDITY

In its simplest form, dark pools of liquidity are private execution venues that lack a quote display and offer anonymous trade executions. There are two broad categories that fall under this definition that this Impact Note has discussed earlier: block trading networks and broker-driven internal crossing platforms. In recent months, much has been written about the potential growth of dark pools of liquidity. The more well-known dark liquidity providers (such as ITG POSIT and Liquidnet) have seen their trade volume soar over the last few quarters. On the lesser-known side of dark pools of liquidity lies bulge bracket firms and their internal crossing engines. Individually considered, these disparate pools of liquidity may not add up to much -- perhaps, on average, 25 to 30 million shares per day for the more successful providers. However, there appears to be cursory discussions taking place amongst some of the large bulge bracket firms to aggregate these disparate liquidity pools to offer a more competitive service to their collective clients. This could potentially take the form of the creation of a single platform or it could virtually link all of the single-broker crossing engines together, which is reminiscent of the linkages created by the ECNs.
Page 25 of 29
SEPTEMBER 2006
One basic problem with dark pools of liquidity is the fact that by definition, they are not easily accessible to all of the market participants. And because of this, dark pools of liquidity face a regulatory dilemma. That is, the success of dark pools of liquidity directly increases the likelihood that regulatory authorities will step in to shed light on the various dark execution venues. This, in turn, could seriously threaten the business strategy of these venues and hence, their competitiveness.
FIGURE 25: PROJECTED GROWTH OF DARK POOLS OF LIQUIDITY IN THE U.S. EQUITIES MARKET
Projected Market Share of Dark Pools of Liquidity in the U.S. Equities Market 25% 20% 15% 10% 5% 0% 2006 2007 2008 2009 2010
Source: Aite Group estimates
In addition, crossing and internalization services offered by the bulge bracket firms with significant proprietary trading interests also face the added stigma of competing against their clients order flow. While not easy to prove, this public perception has been one of the stumbling blocks for further adoption of internalization in the past. For these reasons, it is highly unlikely that dark pools of liquidity will become the mainstay of execution in the U.S. equities market. However, they will continue to provide valuable, niche services aimed at satisfying the needs of their clients who are looking for rapid, anonymous execution services, especially when dealing with block-size orders. In addition, as more brokers develop algorithms that seek out dark pools of liquidity, the popularity of these pools will continue to increase.
Page 26 of 29
SEPTEMBER 2006
PROJECTED POSITIONS
ECNS
With the disappearance of INET as a result of its acquisition by NASDAQ, it has now become official: ECNs are dead as an innovative business model. Their market relevance no longer exists in the NASDAQ market. In fact, in order for the smaller ECNs to survive, they will have to look for a buyer. Attain took the first plunge in this regard by being acquired by Knight Securities, followed by NexTrade with Citigroup. BATS, one of the newest entrants, has brought some life back into the overall ECN market. However, with all of the major ECNs disappearing due to M&A activities, ECNs, as an industry, will have a minimum impact on the overall evolution of the equities market.
AT S
Those ATSs in the block trading business should benefit even more from Reg NMS. Extending the Order Protection Rule to block trading has, in essence, made the institutional trading environment even more hostile toward large block orders. Private block trading platforms, such as Liquidnet, ITG, and Pipeline, will continue to be viable execution destinations for those buy-side firms looking for anonymity, speed, and liquidity. These ATSs will remain niche players but will continue to build market share over the next few years. Competition is getting tougher, however. It has been driven by exchanges launching crossing services as well as large sell-side firms building internal crossing engines in the hope of recapturing some of the order flow they have lost to these block trading facilities.
SELL-SIDE
Not surprisingly, large sell-side firms have been quite active in seeking opportunities in this ever-changing competitive landscape: Investments in existing exchanges. Bulge bracket firms have poured millions of dollars into various regional exchanges in recent months. Whether or not order flow will follow these investments is not clear at this point. Purchase of ECNs. Some of the large brokers have opted to buy existing ECNs, such as Knight Securities and Citigroup. This could certainly help these brokers to secure transaction revenue, but it could also improve brokers potential to capture additional revenue through market data distribution.
Page 27 of 29
SEPTEMBER 2006
Development of internal crossing engines. The concept of internalization or internal crossing is nothing new to the securities industry. However, the Reg NMS exemption -- in particular, to the fair access rule threshold of 5% obtained by leading block trading networks, such as Liquidnet -- has pushed large broker-dealers to create competitive private crossing engines in the hope of recapturing lost market share for block trading.
Small- to mid-size agency brokers -- such as Instinet and ITG -- have focused on specializing in technology-driven execution services to remain competitive in todays equities market. For those brokers that continue to rely on traditional cash equities business, their futures may be numbered as the equities market continues to become highly automated. From a regulatory compliance perspective, as the intermediary between the buyside and execution venues, the sell-side will be asked to play an important role in educating, developing plans, and helping buy-side comply with the various new and pending regulations. As a result, sell-side firms will have to develop, deploy, and maintain robust compliance platforms to ensure specific compliance requirements are supported throughout the U.S. equities market. In general, market uncertainty and confusion have been very kind to sell-side firms in the past. The post-Reg NMS market structure will not be an exception to this trend. As the key intermediary, the sell-side has the market knowledge and the market clout to shape the future of the U.S. equities market.
Page 28 of 29
SEPTEMBER 2006
RELATED AITE GROUP REPORTS
U.S. Equities Market in Transition: Evaluating Leading Exchanges, September 2006. U.S. Equities Market in Transition: Looking for Liquidity in All the Wrong Places? August 2006. IT Spending in U.S. Securities & Investments in 2006: The March Towards Automation and Regulatory Compliance, April 2006. Soft Dollars & Bundling: Here to Fight Another Day, April 2006. Compliance in 2006: Blazing Flashes in an Obvious Market, February 2006. Top 10 Securities & Investments Trends in 2006, December 2005. Shaking Up Prime Brokerage: Unbundling Securities Lending, Financing, and Derivatives Transactions, October 2005. Future of Electronic Connectivity: In the Aftermath of Regulation NMS, July 2005. Regulation NMS: Will the Real Winner Please Stand Up? April 2005. Algorithmic Trading: Hype or Reality?, March 2005. IT Spending in U.S. Securities & Investments in 2005: A New Beginning, January 2005.
Page 29 of 29

Aite-Alt Execution Sep2006

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THE U.S. EQUITIES MARKET IN TRANSITION: ALTERNATIVE EXECUTION VENUES

NYSE Group 47%

Exchanges, ECNs, ATSs, Brokers, Aite Group estimates

Sang Lee 617.338.6015 slee@aitegroup.com

Alternative Execution Venues

MARKET STRUCTURE EVOLUTION

Citigroup acquires OnTrade ECN from NexTrade

1987: Launch of ITG POSIT

Knight acquires Attain and renames it Direct Edge ECN

Instinet/Island merger Launch of Track ECN

Launch of BATS ECN NASDAQ acquisition of BRUT Launch of Pipeline

Source: ECNs, Aite Group

Alternative Execution Venues

NYSE NYSE Merger with Archipelago Acquired by NYSE

Alternative Execution Venues

ELECTRONIC COMMUNICATION NETWORKS (ECNS)

November 1999 January 2006 April 2002

Citigroup Tradebot Systems, etc. Track Data Corporation

1.5 million 7.9 million 11.9 million

Alternative Execution Venues

FIGURE 4: ECN MARKET SHARE ANALYSIS

ECN Market Share OnTrade 1% BATS 3%

Direct Edge 29% Bloomberg TradeBook 62%

FIGURE 5: ECNS MARKET SHARE IN THE U.S. EQUITIES MARKET

% of ECN Market Share in U.S. Equities Market Q2 2006 ECNs 6%

U.S. Equities Market 96%

Source: ECNs, NYSE, NASDAQ, Aite Group estimates

Alternative Execution Venues

Alternative Execution Venues

FIGURE 7: SCREENSHOT OF BATS

Alternative Execution Venues

DIRECT EDGE ECN

Direct Edge Average Daily Trade Volum e

Source: Direct Edge ECN

Alternative Execution Venues

FIGURE 9: BREAKDOWN OF DIRECT EDGE ECN VOLUME

Details Behind Direct Edge ECN Trade Volum e

Routed Out 45% Internal Match 55%

Average Daily Trade Volum e = 70 m illion shares

Source: Direct Edge ECN

Alternative Execution Venues

Pipeline NYFIX Millennium

Source: Firms, Aite Group estimates

Alternative Execution Venues

Pre-Trade Analytics ITG Logic

Trade & Execution POSIT

Post-Trade Analysis TCA Fair Value Model Plexus

ITG Algorithms ITG Trading Services ITG Hoenig

Alternative Execution Venues

FIGURE 11: AVERAGE DAILY SHARE VOLUME

POSIT's Average Daily Share Volum e

Average Daily Share Volume

Alternative Execution Venues

Alternative Execution Venues

Liquidnet Mem bership Europe 14%

Liquinet's Average Daily Share Volum e

Average Daily Share Volume

Alternative Execution Venues

FIGURE 15: LIQUIDNET STATISTICS BASED ON EXCHANGE

Alternative Execution Venues

Total Principal Traded 8,262

3,158 1,492 1,955