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KCG HOLDINGS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Explanatory Note On July 1, 2013, Knight Capital Group, Inc. ("Knight"), through a series of transactions (the "Mergers"), merged with GETCO Holding Company, LLC ("GETCO") to form KCG Holdings, Inc. ("KCG" or the "Company"). The Mergers were consummated pursuant to the Amended and Restated Agreement and Plan of Merger, dated as of December 19, 2012 and amended and restated as of April 15, 2013 (the "Merger Agreement"). Following the Mergers, each of Knight and GETCO became a wholly-owned subsidiary of KCG. All references herein to the "Company", "we", "our" or "KCG" relate solely to KCG and not Knight. All references to "GETCO" relate solely to GETCO and not KCG. The Mergers were treated as a purchase of Knight by GETCO for accounting and financial reporting purposes. As a result, the financial results for the nine months ended September 30, 2013 comprise three months of results of KCG plus six months of GETCO and the financial results for the three months ended September 30, 2014 and 2013 and the nine months ended September 30, 2014, comprise the results of KCG. All GETCO earnings per share and unit share outstanding amounts in this Quarterly Report on Form 10-Q have been calculated as if the conversion of GETCO units to KCG Class A Common Stock took place on January 1, 2013, at the exchange ratio, as defined in the Merger Agreement. Cautionary Statement Regarding Forward-Looking Information Certain statements contained in this Quarterly Report on Form 10-Q, including without limitation, those under "Management's Discussion and Analysis of Financial Condition and Results of Operations" herein ("MD&A"), "Quantitative and Qualitative Disclosures About Market Risk" in Part I, Item 3, "Legal Proceedings" and "Risk Factors" in Part II and the documents incorporated by reference herein may constitute "forward-looking statements" within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are typically identified by words such as "believe," "expect," "anticipate," "intend," "target," "estimate," "continue," "positions," "prospects" or "potential," by future conditional verbs such as "will," "would," "should," "could" or "may," or by variations of such words or by similar expressions. These forward-looking statements are not historical facts and are based on current expectations, estimates and projections about the Company's industry, management's beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond the Company's control. Any forward-looking statement contained herein speaks only as of the date on which it is made. Accordingly, readers are cautioned that any such forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict including, without limitation, risks associated with: (i) the Mergers including, among other things, (a) difficulties and delays in integrating the Knight and GETCO businesses or fully realizing cost savings and other benefits, (b) the inability to sustain revenue and earnings growth, and (c) customer and client reactions to the Mergers; (ii) the August 1, 2012 technology issue that resulted in Knight's broker dealer subsidiary sending numerous erroneous orders in NYSE-listed and NYSE Arca securities into the market and the impact to Knight's capital structure and business as well as actions taken in response thereto and consequences thereof; (iii) the sale of KCG's reverse mortgage origination and securitization business, pending sale of KCG's futures commission merchant and the pending strategic review of KCG Hotspot; (iv) changes in market structure, legislative, regulatory or financial reporting rules, including the increased focus by regulators, the New York Attorney General, Congress and the media on market structure issues, and in particular, the scrutiny of high frequency trading, alternative trading systems ("ATS") manner of operations, market fragmentation, colocation, access to market data feeds, and remuneration arrangements such as payment for order flow and exchange fee structures; (v) past or future changes to KCG's organizational structure and management; (vi) KCG's ability to develop competitive new products and services in a timely manner and the acceptance of such products and services by KCG's customers and potential customers; (vii) KCG's ability to keep up with technological changes; (viii) KCG's ability to effectively identify and manage market risk, operational and technology risk, legal risk, liquidity risk, reputational risk, counterparty and credit risk, international risk, regulatory risk, and compliance risk; (ix) the cost and other effects of material contingencies, including litigation contingencies, and any adverse judicial, administrative or arbitral rulings or proceedings; and (x) the effects of increased competition and KCG's ability to maintain and expand market share. The above list is not exhaustive. Because forward-looking statements involve risks and uncertainties, the actual results and performance of the Company may materially differ from the results expressed or implied by such statements. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. Unless otherwise required by law, the Company also disclaims any obligation to update its view of any such risks or 50 -------------------------------------------------------------------------------- uncertainties or to announce publicly the result of any revisions to the forward-looking statements made herein. Readers should carefully review the risks and uncertainties disclosed in the Company's reports with the SEC, including, without limitation, those detailed under "Certain Factors Affecting Results of Operations" in MD&A herein and under "Risk Factors" in Part II, Item 1A of the Company's Annual Report on Form 10-K for the year ended December 31, 2013, and in other reports or documents the Company files with, or furnishes to, the SEC from time to time. This information should be read in conjunction with the Company's Consolidated Financial Statements and the Notes thereto contained in this Quarterly Report on Form 10-Q, and in other reports or documents the Company files with, or furnishes to, the SEC from time to time. Executive Overview We are a leading independent securities firm offering clients a range of services designed to address trading needs across asset classes, product types and time zones. The Company combines advanced technology with specialized client service across market making, agency execution and trading venues and also engages in principal trading via exchange-based market making. KCG has multiple access points to trade global equities, options, futures, fixed income, foreign currencies and commodities via voice or automated execution. On December 19, 2012, Knight, and GETCO entered into the Merger Agreement. The Mergers were approved by the respective stockholders and unitholders of both companies at special meetings held on June 25, 2013, and the Mergers were completed on July 1, 2013. As a result of the Mergers, Knight and GETCO became wholly-owned subsidiaries of KCG. Pursuant to the Merger Agreement, each outstanding share of Knight Class A common stock, par value $0.01 per share ("Knight Common Stock") was converted into the right to elect to receive either $3.75 per share in cash or one third of a share of KCG Class A Common Stock. As a result of the elections and proration procedures provided in the Merger Agreement, former Knight stockholders received a cash payment, in aggregate, of $720.0 million and 41.9 million shares of KCG Class A Common Stock. Upon completion of the Mergers, GETCO unitholders received, in aggregate, 75.9 million shares of KCG Class A Common Stock and 24.3 million warrants to acquire shares of KCG Class A Common Stock. The warrants comprise 8.1 million Class A warrants, having a $12.00 exercise price and exercisable for a four-year term; 8.1 million Class B warrants, having a $13.50 exercise price and exercisable for a five-year term; and 8.1 million Class C warrants, having a $15.00 exercise price and exercisable for a six-year term (collectively the "KCG Warrants"). The Mergers are accounted for as a purchase of Knight by GETCO under accounting principles generally accepted in the United States of America ("GAAP"). Under the purchase method of accounting, the assets and liabilities of Knight were recorded, as of completion of the Mergers, at their respective fair values and added to the carrying value of GETCO's existing assets and liabilities. The reported financial condition and results of operations of KCG following completion of the Mergers reflect Knight's and GETCO's balances and reflect the impact of purchase accounting adjustments, including revised amortization and depreciation expense for acquired assets. As GETCO is the accounting acquirer under GAAP, all financial information prior to the Mergers is that of GETCO. Results of Operations As of September 30, 2014, our operating segments comprised the following: • Market Making- Our Market Making segment principally consists of market making in the cash, futures and options markets across global equities, options, fixed income, foreign currencies and commodities. As a market maker, we commit capital on a principal basis by offering to buy securities from, or sell securities to, broker dealers, institutions and banks. Principal trading in the Market Making segment primarily consists of direct-to-client and non-client exchange-based electronic market making, including trade executions conducted as an equities Designated Market Maker ("DMM") on the New York Stock Exchange ("NYSE") and NYSE Amex Equities ("NYSE Amex"). We are an active participant on all major global equity and futures exchanges and also trade on substantially all domestic electronic options exchanges. As a complement to electronic market making, our cash trading business handles specialized orders and also transacts on the OTC Bulletin Board, marketplaces operated by the OTC Markets Group Inc. and the Alternative Investment Market ("AIM") of the London Stock Exchange. • Global Execution Services- Our Global Execution Services segment comprises agency execution services and trading venues, offering trading in global equities, options, foreign exchange, fixed income and futures to institutions, banks and broker dealers. We generally earn commissions as an agent between principals 51-------------------------------------------------------------------------------- to transactions that are executed within this segment, however, we will commit capital on behalf of clients as needed. Agency-based, execution-only trading in the segment is done primarily through a variation of access points: (i) self-directed trading in global equities through a suite of algorithms or via our execution management system; (ii) institutional high touch sales traders executing program, block and riskless principal trades in global equities and exchange traded funds ("ETFs"); (iii) an institutional spot foreign exchange electronic communication network ("ECN"); (iv) a fixed income ECN that also offers trading applications; (v) an ATS for global equities; and (vi) futures execution and clearing through a futures commission merchant ("FCM"). • Corporate and Other- Our Corporate and Other segment invests principally in strategic financial services-oriented opportunities, allocates, deploys and monitors all capital, and maintains corporate overhead expenses and all other income and expenses that are not attributable to the other segments. Our Corporate and Other segment also contains functions that support our other segments such as self-clearing services, including stock lending activities. Management from time to time conducts a strategic review of our businesses and evaluates their potential value in the marketplace relative to their current and expected returns. To the extent management and our Board of Directors determine a business may return a higher value to stockholders, or is no longer core to our strategy, the Company may divest or exit such business. In September 2014, we entered into an agreement to sell certain assets and liabilities related to our FCM business. The transaction, which is subject to customary closing conditions and regulatory approvals, is expected to close in the fourth quarter of 2014. On October 30, 2014, we announced that we began to explore strategic options for KCG Hotspot, with the goal of executing on opportunities if it creates additional value for our stockholders, clients and employees. We have not made a decision to enter into any transaction and there can be no assurance that we will enter into such a transaction in the future. The following table sets forth: (i) Revenues, (ii) Expenses and (iii) Pre-tax (loss) earnings from continuing operations of our segments and on a consolidated basis (in thousands): For the three months ended September 30, For the nine months ended September 30, 2014 2013 2014 2013 Market Making Revenues $ 166,620 $ 240,110 $ 662,412 $ 455,678 Expenses 174,653 192,257 558,409 400,016 Pre-tax (loss) earnings (8,033 ) 47,853 104,003 55,662 Global Execution Services Revenues 79,218 91,366 252,341 113,700 Expenses 80,882 107,720 251,253 135,002 Pre-tax (loss) earnings (1,664 ) (16,354 ) 1,088 (21,302 ) Corporate and Other Revenues 26,464 137,862 55,339 134,584 Expenses 32,002 47,988 101,774 127,267 Pre-tax (loss) earnings (5,538 ) 89,874 (46,435 ) 7,317 Consolidated Revenues 272,302 469,338 970,092 703,962 Expenses 287,537 347,965 911,436 662,285 Pre-tax (loss) earnings $ (15,235 ) $ 121,373 $ 58,656 $ 41,677 Totals may not add due to rounding. In the first quarter of 2014, the Company began to charge the Market Making and Global Execution Services segments for the cost of aggregate debt interest. The interest amount charged to each of the segments is determined based on capital limits and requirements. Historically, debt interest was included within the Corporate and Other segment. This change in the measurement of segment profitability has no impact on the consolidated results and will only be reported prospectively, and will not be reflected in any financial results prior to January 1, 2014. For the three 52 -------------------------------------------------------------------------------- months ended September 30, 2014 debt interest expense included in the results of the Market Making and Global Execution Services segments was $6.1 million and $1.6 million, respectively. For the nine months ended September 30, 2014 debt interest expense included in the results of the Market Making and Global Execution Services segments was $19.1 million and $5.9 million, respectively. Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax Earnings We believe that certain non-GAAP financial presentations, when taken into consideration with the corresponding GAAP financial presentations, are important in understanding our operating results. The non-GAAP adjustments incorporate the effects of the writedown of capitalized debt costs related to early repayment of debt; gains and losses from strategic assets; professional and other fees related to the Mergers; compensation expense related to reductions in workforce and other employee separations; writedowns of assets and lease loss accruals primarily related to office consolidations. We believe the presentation of results excluding these adjustments provides meaningful information to stockholders and investors as they provide a useful summary of our results of operations for the three and nine months ended September 30, 2014 and 2013. The following tables provide a full reconciliation of GAAP to non-GAAP pre- tax results ("adjusted pre-tax earnings") for the three and nine months ended September 30, 2014 and 2013 (in thousands): Global Three months ended September 30, Execution Corporate and 2014 Market Making Services Other Consolidated Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax: GAAP Loss from continuing operations before income taxes $ (8,033 ) $ (1,664 ) $ (5,538 ) $ (15,235 ) Net gain related to tradeMONSTER combination with OptionsHouse - - (15,105 ) (15,105 ) Compensation related to reduction in workforce and other employee separations 2,786 3,577 4,158 10,521 Writedown of assets and lease loss accrual, net - - 301 301 Adjusted pre-tax earnings $ (5,247 ) $ 1,913 $ (16,184 ) $ (19,518 ) Totals may not add due to rounding Global Three months ended September 30, Execution Corporate and 2013 Market Making Services Other Consolidated Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax: GAAP Income (loss) from continuing operations before income taxes $ 47,853 $ (16,354 ) $ 89,874 $ 121,373 Gain on investment in Knight Capital Group, Inc. - - (127,972 ) (127,972 ) Compensation and other expenses related to reduction in workforce 2,309 15,132 - 17,441 Professional and other fees related to Mergers and August 1st technology issue - - 7,269 7,269 Writedown of assets and lease loss accrual 108 - 828 936 Adjusted pre-tax earnings $ 50,270 $ (1,222 ) $ (30,001 ) $ 19,047 Totals may not add due to rounding 53 -------------------------------------------------------------------------------- Global Execution Corporate and Nine months ended September 30, 2014 Market Making Services Other Consolidated Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax: GAAP Income (loss) from continuing operations before income taxes $ 104,003 $ 1,088 $ (46,435 ) $ 58,656 Net gain related to tradeMONSTER combination with OptionsHouse - - (15,105 ) (15,105 ) Income resulting from the merger of BATS and Direct Edge, net - - (9,644 ) (9,644 ) Compensation related to reduction in workforce and other employee separations 3,169 5,463 4,958 13,590 Writedown of capitalized debt costs - - 9,552 9,552 Writedown of assets and lease loss accrual, net 811 - 1,697 2,508 Adjusted pre-tax earnings $ 107,983 $ 6,551 $ (54,977 ) $ 59,557 Totals may not add due to rounding Global Execution Corporate and Nine months ended September 30, 2013 Market Making Services Other Consolidated Reconciliation of GAAP Pre-Tax to Non-GAAP Pre-Tax: GAAP Income (loss) from continuing operations before income taxes $ 55,662 $ (21,302 ) $ 7,317 $ 41,677 Gain on investment in Knight Capital Group, Inc. - - (127,972 ) (127,972 ) Professional and other fees related to Mergers and August 1st technology issue - - 44,398 44,398 Compensation and other expenses related to reduction in workforce 6,264 15,997 - 22,261 Unit based compensation acceleration due to Mergers - - 22,031 22,031 Strategic asset impairment - - 9,184 9,184 Writedown of assets and lease loss accrual 108 - 4,525 4,633 Adjusted pre-tax earnings $ 62,034 $ (5,305 ) $ (40,517 ) $ 16,212 Totals may not add due to rounding A summary of the changes in our financial results and balances follows. The primary reason for the variance between the nine months ended September 30, 2014 and 2013 results is the Mergers which occurred on July 1, 2013. Financial results for periods prior to the Mergers reflect solely the results of GETCO while periods following the Mergers reflect the results of KCG which includes both GETCO and Knight. Consolidated revenues for the three months ended September 30, 2014 decreased $197.0 million from the same period a year ago, while consolidated expenses decreased $60.4 million. Consolidated pre-tax loss from continuing operations for the three months ended September 30, 2014 was $15.2 million as compared to a consolidated pre-tax earnings of $121.4 million for the same period a year ago. The Company's net revenues, which it defines as total revenues, less execution and clearance fees, payments for order flow, collateralized financing interest and gains (losses) on investments subtracted (added) to get to adjusted pre-tax earnings ("adjusted net revenues") were $160.4 million for the three months ended September 30, 2014, compared to $239.4 million for the comparable period in 2013. Adjusted pre-tax earnings decreased from $19.0 million in the third quarter of 2013 to a loss of $19.5 million in the third quarter of 2014. Consolidated revenues for the nine months ended September 30, 2014 increased $266.1 million from the same period a year ago, while consolidated expenses increased $249.2 million. Consolidated pre-tax earnings from continuing operations for the nine months ended September 30, 2014 was $58.7 million as compared to a consolidated pre-tax loss of $41.7 million for the same period a year ago. The Company's adjusted net revenues were $647.2 million for the nine months ended September 30, 2014, compared to $395.3 million for the comparable period in 2013. Adjusted pre-tax earnings increased from $16.2 million in the first three quarters of 2013 to $59.6 million in the first three quarters of 2014. 54 -------------------------------------------------------------------------------- Adjusted pre-tax earnings for the three and nine months ended September 30, 2014 exclude net non-GAAP adjustments totaling a net benefit of $4.3 million and a net charge of $0.9 million, respectively. These items primarily comprise the net gain related to tradeMONSTER's combination with OptionsHouse and the BATS Global Markets Inc. ("BATS") and Direct Edge Holdings LLC ("Direct Edge") merger offset, in part, by compensation related to reductions in workforce and other employee separations, writedown of capitalized debt costs and writedown of assets and lease loss accruals.. Adjusted pre-tax earnings for the three and nine months ended September 30, 2013 exclude net non-GAAP adjustments totaling a net benefit of $102.3 million and $25.5 million, respectively. These items primarily comprise a gain on the Company's investment in Knight Capital Group, Inc. offset, in part, by professional and other fees related to the Mergers, compensation expense related to the Mergers and reduction in workforce, impairment of a strategic asset and writedown of assets and lease loss accruals. A detailed breakdown of these items can be found in the Reconciliation of GAAP pre-tax to Non-GAAP pre-tax earnings tables above. The changes in our adjusted pre-tax earnings by segment from the three and nine months ended September 30, 2013 are summarized as follows: • Market Making- Our adjusted pre-tax earnings from Market Making for the three months ended September 30, 2014 was a loss of $5.2 million, compared to adjusted pre-tax earnings of $50.3 million for the comparable period in 2013. Our adjusted pre-tax earnings from Market Making for the nine months ended September 30, 2014 was $108.0 million, compared to adjusted pre-tax earnings of $62.0 million for the comparable period in 2013. Results for the current quarter were negatively impacted by lower market volumes and volatility combined with high levels of competition as well as weak U.S. equity revenue capture. These factors affected the decreases in both our direct-to-client and non-client market making strategies. Results for the nine months ended September 30, 2014 compared to the prior period were driven by the acquisition of Knight and its direct-to-client market making strategies. • Global Execution Services- Our adjusted pre-tax earnings from Global Execution Services for the three months ended September 30, 2014 was $1.9 million, compared to an adjusted pre-tax loss of $1.2 million for the comparable period in 2013. Our adjusted pre-tax earnings from Global Execution Services for the nine months ended September 30, 2014 was $6.6 million, compared to an adjusted pre-tax loss of $5.3 million for the comparable period in 2013. Despite a quarter in which market volumes across many products declined, results for the current quarter and first nine months of 2014 were aided by solid results from businesses such as KCG Hotspot, KCG BondPoint as well as KCG EMS, which includes Knight Direct and GETAlpha. • Corporate and Other- Our adjusted pre-tax earnings from our Corporate and Other segment was a loss of $16.2 million for the three months ended September 30, 2014 compared to a loss of $30.0 million for the comparable period in 2013. Our adjusted pre-tax earnings from our Corporate and Other segment was a loss of $55.0 million for the nine months ended September 30, 2014 compared to a loss of $40.5 million for the comparable period in 2013. Results for the current quarter were aided by the cost efficiencies we have created since the completion of the Mergers as well as the change in measurement of our segments as a result of charging both Market Making and Global Execution Services with debt interest which was not done in 2013. On a year over year basis, a larger infrastructure, including additional corporate employees, a stock lending business and other required costs associated with being a public company all contributed to the additional expense within this segment. Certain Factors Affecting Results of Operations We may experience significant variation in our future results of operations. Fluctuations in our future performance may result from numerous factors, including, among other things, global financial market conditions and the resulting competitive, credit and counterparty risks; cyclicality, seasonality and other economic conditions; the value of our securities positions and other financial instruments and our ability to manage the risks attendant thereto; the volume, notional dollar value traded and volatility levels within the core markets where our market making and trade execution businesses operate; the composition, profile and scope of our relationships with institutional and broker dealer clients; the performance, size and volatility of our direct-to-client market making portfolios; the performance, size and volatility of our non-client exchange-based trading activities; the overall size of our balance sheet and capital usage; impairment of goodwill and/or intangible assets; the performance of our global operations, trading technology and technology infrastructure; the effectiveness of our self-clearing and futures platforms and our ability to manage risks related thereto; the availability of credit and liquidity in the marketplace; our ability to prevent erroneous trade orders from being 55 -------------------------------------------------------------------------------- submitted due to technology or other issues (such as the events that affected Knight on August 1, 2012) and avoiding the consequences thereof; the performance, operation and connectivity to various market centers; our ability to manage personnel, compensation, overhead and other expenses, including our occupancy expenses under our office leases and expenses and charges relating to legal and regulatory proceedings; the strength of our client relationships; changes in payments for order flow; changes to execution quality and changes in clearing, execution and regulatory transaction costs; interest rate movements; the addition or loss of executive management, sales, trading and technology professionals; geopolitical, legislative, legal, regulatory and financial reporting changes specific to financial services and global trading; legal or regulatory matters and proceedings; the Mergers and the costs and integration associated therewith; the amount, timing and cost of business divestitures/acquisitions or capital expenditures; the integration, performance and operation of acquired businesses; the incurrence of costs associated with acquisitions and dispositions; investor sentiment; and technological changes and events. Such factors may also have an impact on our ability to achieve our strategic objectives, including, without limitation, increases in market share, growth and profitability in the businesses in which we operate. If demand for our services declines or our performance deteriorates significantly due to any of the above factors, and we are unable to adjust our cost structure on a timely basis, our operating results could be materially and adversely affected. As a result of the foregoing factors, period-to-period comparisons of our revenues and operating results are not necessarily meaningful and such comparisons cannot be relied upon as indicators of future performance. There also can be no assurance that we will be able to continue to achieve the level of revenues that we have experienced in the past or that we will be able to improve our operating results. Trends Global Economic Trends Our businesses are affected by many factors in the global financial markets and worldwide economic conditions. These factors include the growth level of gross domestic product in the U.S., Europe and Asia, and the existence of transparent, efficient and liquid equity and debt markets and the level of trading volumes and volatility in such markets. During both the three and nine months ended September 30, 2014, trade volume and volatility levels across equity markets decreased from the comparable prior year periods as did similar trading metrics generally across all products we execute. Overall, there are still concerns about global stability and growth, inflation and declining asset values. Trends Affecting Our Company We believe that our businesses are affected by the aforementioned global economic trends as well as more specific trends. Some of the specific trends that impact our operations, financial condition and results of operations are: • Clients continue to focus on statistics measuring the quality of equity executions (including speed of execution and price improvement). In an effort to improve the quality of their executions as well as increase efficiencies, market makers continue to increase the level of sophistication and automation within their operations and the extent of price improvement. The continued focus on execution quality has resulted in greater competition in the marketplace, which, along with market structure changes and market conditions, has negatively impacted the revenue capture and margin metrics of the Company and other market making firms. • Market Making and Global Execution Services transaction volumes executed by clients have fluctuated over the past few years due to retail and institutional investor sentiment, market conditions and a variety of other factors. Market Making and Global Execution Services transaction volumes may not be sustainable and are not predictable. • Over the past several years exchanges have become far more competitive, and market participants have created ATS, ECNs and other execution venues which compete with the OTC and listed trading venues. Initiatives by these and other market participants could draw market share away from the Company, and thus negatively impact our business. In addition, there are many new entrants into the market, including ATS, Multilateral Trading Facilities, systematic internalizers, dark liquidity pools, high frequency trading firms, and market making firms competing for retail and institutional order flow. Further, many broker dealers offer their own internal crossing networks. These factors continue to create further fragmentation and competition in the marketplace. 56-------------------------------------------------------------------------------- • Market structure changes, competition, market conditions and a steady increase in electronic trading have resulted in a reduction in institutional commission rates and volumes which may continue in the future. Additionally, many institutional clients allocate commissions to broker dealers based not only on the quality of executions, but also in exchange for research, or participation in soft dollar and commission recapture programs. • There continues to be growth in electronic trading, including direct market access platforms, algorithmic and program trading, high frequency trading ECNs, ATS and dark liquidity pools. In addition, electronic trading continues to expand to other asset classes, including options, currencies and fixed income. The expansion of electronic trading may result in the growth of innovative electronic products and competition for order flow and may further reduce demand for traditional institutional voice services. • Market structure changes, competition and technology advancements have led to an industry focus on increasing execution speeds and a dramatic increase in electronic message traffic. Increases in execution speeds and message traffic require additional expenditures for technology infrastructure and place heavy strains on the technology resources, bandwidth and capacities of market participants. Additionally, the expansion by market participants into trading of non-equities products offers similar challenges. • There has been increased scrutiny of the capital markets industry by the regulatory and legislative authorities, both in the U.S. and abroad, which could result in increased regulatory costs in the future. As has been widely reported, there has been an increased focus by regulators, the New York Attorney General, Congress and the media on market structure issues, and in particular, high frequency trading, ATS manner of operations, market fragmentation and complexity, colocation, access to market data feeds and remuneration arrangements such as payment for order flow and exchange fee structures. New legislation or new or modified regulations and rules could occur in the future. Members of the U.S. Congress continue to ask the SEC and other regulators to closely review the financial markets regulatory structure and make the changes necessary to insure the rule framework governing the U.S. financial markets is comprehensive and complete. The SEC and other regulators, both in the U.S. and abroad, have adopted and will continue to propose and adopt rules and take other policy actions where necessary, on a variety of marketplace issues - including, but not limited to: high frequency trading, market fragmentation and complexity, transaction taxes, off-exchange trading, dark liquidity pools, internalization, post-trade attribution, colocation, market access, short sales, consolidated audit trails, policies and procedures relating to technology controls and systems, and market volatility rules (including, Regulation Systems Compliance and Integrity commonly referred to as, Regulation SCI). • We expect increases, possibly substantial, in Section 31 fees and fees imposed by other regulators. In addition, the Depository Trust & Clearing Corporation ("DTCC") and National Securities Clearing Corporation ("NSCC") are considering proposals which could require substantial increases in clearing margin, liquidity and collateral requirements. • The Dodd-Frank Act affects nearly all financial institutions that operate in the U.S. While the weight of the Dodd-Frank Act falls more heavily on large, complex financial institutions, smaller institutions will continue to face a more complicated and expensive regulatory framework. Income Statement Items The following section briefly describes the key components of, and drivers to, our significant revenues and expenses. Revenues Our revenues consist principally of Trading revenues, net and Commissions and fees from all of our business segments. Trading profits and losses on principal transactions primarily relate to our global market making activities and are included within Trading revenues, net. These revenues are primarily affected by changes in the amount and mix of equity trade and share volumes; our revenue capture, dollar value of equities traded, fixed income, options, futures and FX trading volume and strategies; our ability to derive trading gains by taking proprietary positions; changes in our execution standards; development of, and enhancement to, our market making models; performance of our direct-to-client and non-client trading models; volatility in the marketplace; our mix of broker dealer and institutional clients; client service and relationships and regulatory changes and evolving industry customs and practices. 57 -------------------------------------------------------------------------------- Revenues on transactions for which we charge explicit commissions or commission equivalents, which include the majority of our institutional client orders and commissions on futures transactions are included within Commissions and fees. Also included in Commissions and fees are volume based fees earned from providing liquidity to other trading venues. Commissions and fees are primarily affected by changes in our equity, fixed income, futures and foreign exchange transaction volumes with institutional clients; client relationships; changes in commission rates; client experience on the various platforms; level of volume based fees from providing liquidity to other trading venues; and the level of our soft dollar and commission recapture activity. Interest, net is earned from our cash held at banks, cash held in trading accounts at third party clearing brokers and from collateralized financing arrangements, such as securities borrowing. The Company's third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by clearing brokers for facilitating the settlement and financing of securities transactions. Net interest is primarily affected by interest rates; the level of cash balances held at banks and third party clearing brokers including those held for customers; the level of our securities borrowing activity; our level of securities positions in which we are long compared to our securities positions in which we are short; and the extent of our collateralized financing arrangements. Investment income and other, net primarily represents returns on our strategic and deferred compensation investments. Such income or loss is primarily affected by the performance and activity of our strategic investments. Expenses Employee compensation and benefits expense primarily consists of salaries and wages paid to all employees; performance-based compensation, which includes compensation paid to sales personnel and incentive compensation paid to other employees based on our performance; employee benefits; and stock and unit-based compensation. Employee compensation and benefits expense fluctuates, for the most part, based on changes in our revenues and business mix, profitability and the number and mix of employees. Compensation for certain employees engaged in sales activities is determined primarily based on a percentage of their gross revenues net of certain transaction-based expenses. Execution and clearance fees primarily represent fees paid to third party clearing brokers for clearing equities, options and fixed income transactions; transaction fees paid to Nasdaq and other exchanges, clearing organizations and regulatory bodies; and execution fees paid to third parties, primarily for executing trades on the NYSE, other exchanges and ECNs. Execution and clearance fees primarily fluctuate based on changes in trade and share volume, execution strategies, rate of clearance fees charged by clearing brokers and rate of fees paid to ECNs, exchanges and certain regulatory bodies. Communications and data processing expense primarily consists of costs for obtaining market data, connectivity, telecommunications services, co-location and systems maintenance. Payments for order flow primarily represent payments to broker dealer clients, in the normal course of business, for directing to us their order flow in U.S. equities and options. Payments for order flow will fluctuate as we modify our rates and as our percentage of clients whose policy is not to accept payments for order flow varies. Payments for order flow also fluctuate based on U.S. equity share and option volumes, our profitability and the mix of market orders, limit orders, and customer mix. Depreciation and amortization expense results from the depreciation of fixed assets, which consist of computer hardware, furniture and fixtures, and the amortization of purchased software, capitalized software development costs, acquired intangible assets and leasehold improvements. We depreciate our fixed assets and amortize our intangible assets on a straight-line basis over their expected useful lives. We amortize leasehold improvements on a straight-line basis over the lesser of the life of the improvement or the remaining term of the lease. Debt interest expense consists primarily of costs associated with our debt and capital lease obligations. Collateralized financing interest consists primarily of costs associated with financing arrangements such as securities lending and sale of financial instruments under our agreements to repurchase. Occupancy and equipment rentals consist primarily of rent and utilities related to leased premises and office equipment. Professional fees consist primarily of legal, accounting, consulting, and other professional fees. 58 -------------------------------------------------------------------------------- Business development consists primarily of costs related to sales and marketing, conferences and client relationship management. Writedown of capitalized debt costs represents charges recorded as the result of the repayment of our debt. Writedown of assets and lease loss accrual consist primarily of costs associated with the writedown of assets which management has determined to be impaired and adjustments to lease loss accruals related to excess office space. Other expenses include regulatory fees, corporate insurance, employment fees, amortization of capitalized debt costs and general office expense. Three Months Ended September 30, 2014 and 2013 Revenues Market Making For the three months ended September 30, 2014 2013 Change % of Change Trading revenues, net (thousands) $ 144,109 $ 219,412 $ (75,303 ) (34.3 )% Commissions and fees (thousands) 28,891 25,122 3,769 15.0 % Interest, net and other (thousands) (6,381 ) (4,425 ) (1,956 ) N/M Total Revenues from Market Making (thousands) $ 166,620 $ 240,110 (73,491 ) (30.6 )% U.S. equity Market Making statistics: Average daily dollar value traded ($ millions) 24,726 25,365 (639 ) (2.5 )% Average daily trades (thousands) 3,326 3,809 (483 ) (12.7 )% NYSE and Nasdaq shares traded (millions) 727 805 (78 ) (9.7 )% OTC Bulletin Board and OTC Market shares traded (millions) 5,060 3,343 1,717 51.4 % Average revenue capture per U.S. equity dollar value traded(bps) 0.75 1.01 (0.26 ) (25.7 )% Totals may not add due to rounding. N/M - Not meaningful Total revenues from the Market Making segment, which primarily comprises Trading revenues, net and Commissions and fees from our domestic businesses, were $166.6 million for the three months ended September 30, 2014 and $240.1 million for the comparable period in 2013. Revenues for the three months ended September 30, 2014 declined due to overall lower market volumes and volatility which impacted the performance of both our direct-to-client and non-client trading strategies. These factors along with competition and increased price improvement, which gives our clients better prices on trades, but lowers our revenues earned on trades, contributed to weak U.S. equity revenue capture. Average revenue capture per U.S. equity dollar value traded was 0.75 basis points ("bps") for the third quarter of 2014, down 25.7% from 1.01 bps from the third quarter of 2013. Average revenue capture per U.S. equity market making dollar value traded is calculated as the total of net domestic market making trading revenues plus volume based fees from providing liquidity to other trading venues (included in Commissions and fees), (collectively "Domestic U.S. Equity Market Making Revenues"), divided by the total dollar value of the related equity transactions. Domestic U.S. Equity Market Making Revenues were $118.4 million and $164.0 million for the three months ended September 30, 2014 and 2013, respectively. 59 -------------------------------------------------------------------------------- Global Execution Services For the three months ended September 30, 2014 2013 Change % of Change Commissions and fees (thousands) $ 73,773 $ 83,958 (10,185 ) (12.1 )% Trading revenues, net (thousands) 6,808 9,856 (3,048 ) (30.9 )% Interest, net and other (thousands) (1,363 ) (2,447 ) 1,084 N/M Total Revenues from Global Execution Services (thousands) $ 79,218 $ 91,366 (12,148 ) (13.3 )% Average daily KCG algorithmic trading and order routing U.S. equities shares traded (millions) 248.2 269.7 (21.5 ) (8.0 )% Average daily KCG Hotspot FX notional foreign exchange dollar value traded ($ billions) 30.3 28.4 1.9 6.5 % Average daily KCG BondPoint fixed income par value traded ($ millions) 126.0 129.1 (3.1 ) (2.4 )% Totals may not add due to rounding. N/M - Not meaningful Total revenues from the Global Execution Services segment, which primarily comprises Commissions and fees and, to a lesser extent, Trading revenues, net from agency execution activity and activity on our venues were $79.2 million for the three months ended September 30, 2014 and $91.4 million for the comparable period in 2013. Revenues were affected by lower trading volumes within our institutional sales trading and on KCG EMS, which includes Knight Direct and GETAlpha, and on KCG BondPoint offset, in part, by higher trading volumes on KCG Hotspot. Corporate and Other For the three months ended September 30, 2014 2013 Change % of Change Total Revenues from Corporate and Other (thousands) $ 26,464 $ 137,862 $ (111,398 ) N/M N/M - Not meaningful Total revenues from the Corporate and Other segment, which represent interest income from our stock borrow activity and gains or losses on strategic investments were $26.5 million for the three months ended September 30, 2014 and $137.9 million for the comparable period in 2013. Revenues for the three months ended September 30, 2014 includes a $15.1 million net gain related to our investment in tradeMONSTER as a result of tradeMONSTER's combination with OptionsHouse. Revenues for the three months ended September 30, 2013 includes a $128.0 million gain on GETCO's investment in Knight Capital Group, Inc. Expenses Employee compensation and benefits expense fluctuates, for the most part, based on changes in our business mix, revenues, profitability and the number and mix of employees. Employee compensation and benefits expense was $95.3 million for the three months ended September 30, 2014 and $129.6 million for the comparable period in 2013. The decrease on a dollar basis was primarily due to the decrease in the number of employees due to a reduction in force and reduced performance-based compensation. Excluding the compensation expense related to a reduction in workforce of $10.5 million, employee compensation and benefits was $84.8 million or 52.8% of adjusted net revenues for the three months ended September 30, 2014. For the comparable period in 2013,excluding the compensation expense related to a reduction in workforce totaling $17.4 million, employee compensation was $112.2 million or 46.9% of adjusted net revenues. The increase in compensation as a percentage of adjusted net revenues related to the significant decrease in revenues of the Company offset, in part, by a decrease in discretionary bonus pools. The number of full time employees decreased to 1,153 at September 30, 2014 as compared to 1,304 at September 30, 2013 (excluding employees of Urban). As of the Merger date of July 1, 2013, the number of full time employees was 1,397 (excluding employees of Urban). Execution and clearance fees were $74.1 million for the three months ended September 30, 2014 and $81.0 million for the comparable period in 2013. Execution and clearance fees fluctuate based on changes in transaction volumes, shift in business mix, regulatory fees and operational efficiencies and scale. Execution and clearance fees were 28.8% of revenues excluding non-recurring gains and losses on investments ("adjusted revenues") for the three months ended September 30, 2014 and 23.7% for the comparable period in 2013. The variance on a percentage of 60 -------------------------------------------------------------------------------- revenues basis primarily relates to a lower revenue base, impacted by the performance of our market making business including lower revenue capture. Communications and data processing expenses were $38.6 million for the three months ended September 30, 2014 and $44.0 million for the comparable period in 2013. Communications and data processing expense primarily relates to market data, co-location and connectivity expenses. The decrease primarily relates to the lower costs due to integration synergies. Depreciation and amortization expense results from the depreciation of fixed assets and the amortization of purchased software, capitalized software development costs, acquired intangible assets and leasehold improvements. Depreciation and amortization expense was $20.3 million for the three months ended September 30, 2014 and $20.1 million for the comparable period in 2013. The increase relates to purchases of fixed assets as well as new assets put into service during the third quarter of 2014. Payments for order flow fluctuate as a percentage of revenue due to changes in volume, client and product mix, client preference, profitability, and competition. Payments for order flow were $15.4 million for the three months ended September 30, 2014 and $16.4 million for the comparable period in 2013. The variance is due to lower payments as a result of lower trading volumes. As a percentage of adjusted revenues, Payments for order flow were 6.0% in the three months ended September 30, 2014 and 4.8% for the comparable period in 2013. Debt interest expense was $7.7 million for the three months ended September 30, 2014 and $19.4 million for the comparable period in 2013. Interest expense decreased as a result of the pay down of $535.0 million of debt. Collateralized financing interest expense was $7.3 million for the three months ended September 30, 2014 and $4.5 million for the comparable period in 2013. Collateralized financing interest expense relates to the funding of our securities positions through stock loan and repurchase agreements. The increase is a result of additional funding being secured from additional parties. Professional fees were $7.2 million for the three months ended September 30, 2014 and $9.1 million for the comparable period in 2013. Excluding the $4.1 million in legal, consulting and investment banking fees related to the Mergers, Professional fees were $5.0 million for the three months ended September 30, 2013. Professional fees increased due to higher legal and consulting fees in the third quarter of 2014. Writedown of assets and lease loss accrual of $0.3 million for the three months ended September 30, 2014and $0.9 million for the three months ended September 30, 2013 comprised the writedown of leasehold improvements and fixed assets in connection with excess real estate capacity. All other expenses were $21.4 million for the three months ended September 30, 2014 and $22.9 million for the comparable period in 2013. The decrease primarily relates to the decrease in Occupancy and equipment rental costs due to our integration efforts and merging of certain office locations. The decrease was partially offset by higher business development expense which increased primarily due to additional client-related events and marketing. Our effective tax rate for the three months ended September 30, 2014 from continuing operations of 38.0% differed from the federal statutory rate of 35% primarily due to state and local taxes offset, in part by the effect of nondeductible charges. Our effective tax rate for the three months ended September 30, 2013 from continuing operations differed from the federal statutory rate of 35% primarily due to the recognition of $103.5 million of deferred tax benefits as a result of GETCO becoming subject to U.S. corporate income taxes following the Mergers. The effect of nondeductible charges including certain compensation and meals and entertainment and the effect of state and local taxes also led to an increase in our effective tax rate for the period. 61 -------------------------------------------------------------------------------- Nine Months Ended September 30, 2014 and 2013 Revenues Market Making For the nine months ended September 30, 2014 2013 Change % of Change Trading revenues, net (thousands) $ 597,794 $ 404,408 $ 193,386 47.8 % Commissions and fees (thousands) 82,887 58,100 24,787 42.7 % Interest, net and other (thousands) (18,270 ) (6,830 ) (11,440 ) N/M Total Revenues from Market Making (thousands) $ 662,412 $ 455,678 206,734 45.4 % Totals may not add due to rounding. N/M - Not meaningful Total revenues from the Market Making segment, which primarily comprises Trading revenues, net and Commissions and fees from our domestic businesses, were $662.4 million for the nine months ended September 30, 2014 and $455.7 million for the comparable period in 2013. Revenues for the nine months ended September 30, 2014 principally reflects the Mergers and were driven by strong U.S. equity revenue capture in the first and second quarters. Specifically, direct-to-client trading strategies performed extremely well in the first half of 2014, but was offset, in part, by lower market volume and volatility in the third quarter which also particularly impacted our non-client trading strategies. Global Execution Services For the nine months ended September 30, 2014 2013 Change % of Change Commissions and fees (thousands) $ 236,808 $ 106,292 $ 130,516 122.8 % Trading revenues, net (thousands) 18,393 9,884 8,509 86.1 % Interest, net and other (thousands) (2,861 ) (2,475 ) (385 ) N/M Total Revenues from Global Execution Services (thousands) $ 252,341 $ 113,701 138,640 121.9 % Totals may not add due to rounding. N/M - Not meaningful Total revenues from the Global Execution Services segment, which primarily comprises Commissions and fees and, to a lesser extent, Trading revenues, net from agency execution activity and activity on our venues were $252.3 million for the nine months ended September 30, 2014 and $113.7 million for the comparable period in 2013. Higher revenues principally reflect the Mergers including the addition and subsequent performance of our high and low touch equity businesses, including KCG EMS, which includes Knight Direct and GETAlpha, as well as trading venues such as KCG Hotspot and KCG BondPoint. Corporate and Other For the nine months ended September 30, 2014 2013 Change % of Change Total Revenues from Corporate and Other (thousands) $ 55,339 $ 134,584 $ (79,244 ) N/M N/M - Not meaningful Total revenues from the Corporate and Other segment, which represent interest income from our stock borrow activity and gains or losses on strategic investments were $55.3 million for the nine months ended September 30, 2014 and $134.6 million for the comparable period in 2013. Revenues for the nine months ended September 30, 2014 includes a $15.1 million net gain related to our investment in tradeMONSTER as a result of tradeMONSTER's combination with OptionsHouse in the third quarter, as well as a $9.6 million gain which comprises a partial realized gain with respect to the Company's investment in Direct Edge as a result of Direct Edge's merger with BATS. Revenues for the nine months ended September 30, 2013 includes a $128.0 million gain on GETCO's investment in Knight Capital Group, Inc. as well as a $9.2 million charge for impairment of a strategic asset. 62 --------------------------------------------------------------------------------Expenses Employee compensation and benefits expense fluctuates, for the most part, based on changes in our business mix, revenues, profitability and the number and mix of employees. Employee compensation and benefits expense was $321.1 million for the nine months ended September 30, 2014 and $237.0 million for the comparable period in 2013. The increase on a dollar basis was primarily due to an increase in the number of employees following the Mergers. Excluding the compensation expense related to a reduction in workforce of $13.6 million, employee compensation and benefits was $307.5 million or 47.5% of adjusted net revenues for the nine months ended September 30, 2014. Excluding the compensation expense related to a reduction in workforce as well as compensation expense related to the Mergers, employee compensation was $192.7 million or 48.8% of adjusted net revenues for the comparable period in 2013. Execution and clearance fees were $222.8 million for the nine months ended September 30, 2014 and $167.9 million for the comparable period in 2013. Execution and clearance fees fluctuate based on changes in transaction volumes, shift in business mix, regulatory fees and operational efficiencies and scale. Execution and clearance fees were 23.6% of adjusted revenues for the nine months ended September 30, 2014 and 28.7% for the comparable period in 2013. The variance on a percentage of revenues basis primarily relates to a larger revenue base as well as improved trading performance. Communications and data processing expenses were $113.7 million for the nine months ended September 30, 2014 and $86.0 million for the comparable period in 2013. Communications and data processing expense primarily relates to market data, co-location and connectivity expenses. The increase relates to the higher costs as a result of the Mergers. Depreciation and amortization expense results from the depreciation of fixed assets and the amortization of purchased software, capitalized software development costs, acquired intangible assets and leasehold improvements. Depreciation and amortization expense was $60.2 million for the nine months ended September 30, 2014 and $36.0 million for the comparable period in 2013. The increase was primarily due to the amortization of fixed assets, leasehold improvements and intangible assets acquired during the Mergers. Payments for order flow fluctuate as a percentage of revenue due to changes in volume, client and product mix, client preference, profitability, and competition. Payments for order flow were $55.5 million for the nine months ended September 30, 2014 and $17.5 million for the comparable period in 2013. The variance is due to the addition of the direct-to-client market making business that was added as part of the Mergers. As a percentage of adjusted revenues, Payments for order flow were 5.9% in the nine months ended September 30, 2014 and 3.0% for the comparable period in 2013. Debt interest expense was $24.7 million for the nine months ended September 30, 2014 and $22.0 million for the comparable period in 2013. Interest expense increased primarily due to interest on the debt financing for the Mergers. Collateralized financing interest expense was $19.9 million for the nine months ended September 30, 2014 and $4.5 million for the comparable period is 2013. Collateralized financing interest expense relates to the funding of our securities positions through stock loan and repurchase agreements which was not part of GETCO's business prior to the Mergers. Professional fees were $19.9 million for the nine months ended September 30, 2014 and $38.9 million for the comparable period in 2013. Excluding the $31.7 million in legal, consulting and investment banking fees related to the Mergers, Professional fees were $7.2 million for the nine months ended September 30, 2013. Professional fees related to being a larger, publicly traded firm as well as integrating the two firms led to an increase in legal, consulting and auditing fees compared to the nine months ended September 30, 2013. Writedown of capitalized debt costs of $9.6 million for the nine months ended September 30, 2014 relates to the writedown of debt issuance costs as a result of the repayment of the remaining $235.0 million principal of the First Lien Credit Facility. Writedown of assets and lease loss accrual of $2.5 million for the nine months ended September 30, 2014 primarily relates to a writedown of excess real estate as we consolidated offices located in Chicago, New York and London during the year. Writedown of assets of $4.2 million for the nine months ended September 30, 2013 comprised the writedown of leasehold improvements and fixed assets in connection with the shutdown of the Company's Palo Alto and Hong Kong offices. 63 -------------------------------------------------------------------------------- All other expenses were $61.6 million for the nine months ended September 30, 2014 and $48.2 million for the comparable period in 2013. These cost increases primarily relate to the addition of the Knight businesses as a result of the Mergers. The increase in Occupancy and equipment rentals expense is due to additional real estate related costs following the Mergers. Business development expense primarily increased due to client-related events and marketing. Other expense includes higher employment fees and insurance costs. In the nine months ended September 30, 2013, Other expense also included $9.5 million in costs related to the Mergers. Our effective tax rate for the nine months ended September 30, 2014 from continuing operations of 37.8% differed from the federal statutory rate of 35% primarily due to state and local taxes offset, in part by the effect of nondeductible charges. Our effective tax rate for the nine months ended September 30, 2013 from continuing operations differed from the federal statutory rate of 35% primarily due to the recognition of $103.5 million of deferred tax benefits as a result of GETCO becoming subject to U.S. corporate income taxes following the Mergers. The effect of nondeductible charges including certain compensation and meals and entertainment and the effect of state and local taxes also led to an increase in our effective tax rate for the period. Financial Condition, Liquidity and Capital Resources Financial Condition We have historically maintained a highly liquid balance sheet, with a substantial portion of our total assets consisting of cash, highly liquid marketable securities and short term receivables. As of September 30, 2014 and December 31, 2013, we had total assets of $7.52 billion and $7.00 billion, respectively, a significant portion of which consisted of cash or assets readily convertible into cash as follows (in thousands): September 30, 2014 December 31, 2013 Cash and cash equivalents $ 540,457 $ 674,281 Financial instruments owned, at fair value: Equities 2,595,507 2,298,785 Listed options 130,931 339,798 Debt securities 123,151 83,256 Collateralized agreements: Securities borrowed 1,711,214 1,357,387 Receivable from brokers, dealers and clearing organizations (1) 547,378 750,440 Total cash and assets readily convertible to cash $ 5,648,638 $ 5,503,947 * Totals may not add due to rounding. (1) Excludes$304.3 million of assets segregated or held in separate accounts under federal or other regulations at December 31, 2013 and $421.6 million and $202.5 million of securities failed to deliver as of September 30, 2014 and December 31, 2013, respectively. Substantially all of the non-cash amounts disclosed in the table above can be liquidated into cash within five business days under normal market conditions, however, the liquidated values may be subjected to haircuts during distressed market conditions as Knight saw following its August 1, 2012 trading loss. Financial instruments owned principally consist of equities and listed options that trade on the NYSE, NYSE Amex and NYSE Arca markets, Nasdaq and on the OTC Bulletin Board as well as U.S. government and non-U.S. government obligations and corporate debt securities, which include short-term bond funds. These financial instruments are used to generate revenues in our Market Making and Global Execution Services segments. Securities borrowed represent the value of cash or other collateral deposited with securities lenders to facilitate our trade settlement process. Receivable from brokers, dealers and clearing organizations include interest bearing cash balances held with third party clearing brokers, including, or net of, amounts related to securities transactions that have not yet reached their contracted settlement date, which is generally within three business days of the trade date. As of September 30, 2014, $1.51 billion of equities have been pledged as collateral to third-parties under financing arrangements. As of December 31, 2013, $1.23 billion of equities were pledged as collateral to third-parties under financing arrangements. 64 -------------------------------------------------------------------------------- Other assets primarily comprises deposits, prepaids and other miscellaneous receivables. The change in the balances of financial instruments owned, receivable from brokers, dealers and clearing organizations and securities borrowed are all consistent with activity of our trading strategies. Our securities inventory fluctuates based on trading volumes, market conditions, trading strategies utilized and our pre-determined risk limits. Total liabilities were $6.03 billion at September 30, 2014 and $5.49 billion at December 31, 2013. Similar to the asset side, the growth in Financial instruments sold, not yet purchased, Collateralized financings and Payable to brokers, dealers and clearing organizations is related to activity of our trading strategies. As noted throughout the document, substantially all of our debt was issued in order to complete the Mergers, while the decrease in the balance since December 31, 2013 is due to repayments of our debt. The "Liquidity and Capital Resources" section below includes a detailed description of the debt. Equity decreased by $23.7 million, from $1.51 billion at December 31, 2013 to $1.49 billion at September 30, 2014. The decrease in equity from December 31, 2013 was primarily a result of our stock repurchase activity during the nine months ended September 30, 2014, offset by our earnings and stock-based compensation activity. Liquidity and Capital Resources We have financed our business primarily through cash generated by operations, a series of debt transactions and the issuance of equity. At September 30, 2014, we had net current assets, which consist of net assets readily convertible into cash including assets segregated or held in separate accounts under federal and other regulations, less current liabilities, of approximately $1.17 billion. Net (loss) income from continuing operations was a net loss of $9.4 million during the three months ended September 30, 2014 compared to net income from continuing operations of $228.6 million for the three months ended September 30, 2013. Included in these amounts were certain non-cash income and expenses such as gains on investments, stock and unit-based compensation, depreciation, amortization and certain non-cash writedowns. Stock and unit-based compensation was $11.6 million and $14.6 million for the three months ended September 30, 2014 and 2013, respectively. Depreciation and amortization expense was $20.3 million and $20.1 million for the three months ended September 30, 2014 and 2013, respectively. We had non-cash charges of $0.3 million and $0.9 million for the writedown of excess real estate and fixed assets at certain locations for the three months ended September 30, 2014 and 2013, respectively. We also had a non-cash net gain of $15.1 million from a business combination involving one of our strategic investments for the three months ended September 30, 2014. We realized a non-cash gain of $128.0 million on GETCO's investment in Knight Common Stock for the three months ended September 30, 2013. Capital expenditures related to our continuing operations were $15.0 million and $2.6 million during the three months ended September 30, 2014 and 2013, respectively. Purchases of investments were $0.1 million during each of the three months ended September 30, 2014 and 2013. Proceeds and distributions received from investments were $8.5 million for the three months ended September 30, 2014 and $2.1 million during the three months ended September 30, 2013. Cash Convertible Senior Subordinated Notes In March 2010, Knight issued $375.0 million aggregate principal amount of Cash Convertible Senior Subordinated Notes (the "Convertible Notes"), due on March 15, 2015, in a private offering exempt from registration under the Securities Act of 1933, as amended. The Convertible Notes bear interest at a rate of 3.50% per year, payable semi-annually in arrears, on March 15 and September 15 of each year, commencing on September 15, 2010 and will mature on March 15, 2015, subject to earlier repurchase or conversion. The Convertible Notes are reported as Debt in our Consolidated Statements of Financial Condition. As a result of the Mergers, on July 1, 2013, KCG became a party to the Convertible Notes. On July 1, 2013, we delivered a notice (the "Convertible Notes Notice") to the holders of the Notes. The Convertible Notes Notice advised holders of the Convertible Notes of the following (among others): • The completion of the Mergers on July 1, 2013 and the results of the election of the holders of KCG Class A Common Stock to receive cash consideration for such KCG Class A Common Stock constitutes a "Fundamental Change"; 65--------------------------------------------------------------------------------• Each holder of the Convertible Notes had the right to deliver a "Fundamental Change Repurchase Notice" requiring the Company to repurchase all or any portion of the principal amount of the Convertible Notes at a Fundamental Change Repurchase Price of 100% of the principal amount plus accrued and unpaid interest on August 5, 2013, the Fundamental Change Repurchase Date; and • The Company deposited with the paying agent an amount of money sufficient to repurchase all of the Convertible Notes to be repurchased; and upon payment by the paying agent such Convertible Notes will cease to be outstanding. On July 1, 2013, $375.0 million, which was the amount needed to repurchase the aggregate amount of Convertible Notes in full at maturity, was deposited in a cash collateral account under the sole dominion and control of the paying agent under the First Lien Credit Facility (the "Collateral Account"). After the Mergers, a total of $257.7 million in principal amount of the Convertible Notes were repurchased using funds deposited in the Collateral Account. The repurchase included accrued and unpaid interest of $3.6 million. In October 2013, after receiving consent from the Holders of the Senior Secured Notes (as defined below), the funds remaining in the Collateral Account were used to repay a portion of the First Lien Credit Facility. As of September 30, 2014 and December 31, 2013 there were no funds in the Collateral Account. As of September 30, 2014 and December 31, 2013, $117.3 million principal amount of the Convertible Notes were outstanding. Debt incurred in connection with Mergers In connection with the Mergers, we entered into a series of debt financing transactions. Described below are the details of these transactions. Senior Secured Notes On June 5, 2013 GETCO Financing Escrow LLC ("Finance LLC"), a wholly-owned subsidiary of GETCO, issued 8.250% senior secured notes due 2018 in the aggregate principal amount of $305.0 million (the "Senior Secured Notes") pursuant to an indenture, dated June 5, 2013 (as amended and supplemented, the "Senior Secured Notes Indenture"). On July 1, 2013, KCG entered into a first supplemental indenture (the "First Supplemental Indenture") pursuant to which KCG assumed all of the obligations of Finance LLC which comprised the Senior Secured Notes plus certain escrow agent fees and expenses of $3.0 million. On July 1, 2013, KCG and certain subsidiary guarantors (the "Guarantors") under the First Lien Credit Facility, as defined below, entered into a Second Supplemental Indenture, whereby the Senior Secured Notes and the obligations under the Senior Secured Notes Indenture will be fully and unconditionally guaranteed on a joint and several basis by the Guarantors and are secured by second-priority pledges and second-priority security interests in, and mortgages on, the collateral securing the First Lien Credit Facility, subject to certain exceptions. The Senior Secured Notes mature on June 15, 2018 and bear interest at a rate of 8.250% per year, payable on June 15 and December 15 of each year, beginning on December 15, 2013. The Senior Secured Notes Indenture contains customary affirmative and negative covenants, including limitations on indebtedness, liens, hedging agreements, investments, loans and advances, asset sales, mergers and acquisitions, dividends, transactions with affiliates, prepayments of other indebtedness, restrictions on subsidiaries and issuance of capital stock. As of September 30, 2014, the Company was in compliance with the covenants. On July 1, 2013, KCG and the Guarantors entered into a joinder to the registration rights agreement dated June 5, 2013, (the "Senior Secured Notes Registration Rights Agreement") between Finance LLC and Jefferies LLC as representative of the initial purchasers of the Senior Secured Notes. Pursuant to the registration rights agreement, KCG shall use commercially reasonable efforts to (i) file an exchange offer registration statement with the SEC with respect to a registered offer to exchange the Senior Secured Notes (the "Exchange Offer"), (ii) issue in exchange for the Senior Secured Notes a new series of exchange notes within 365 days after June 5, 2013, and, (iii) in certain circumstances, file a shelf registration statement with respect to resales of the Senior Secured Notes. If KCG and the Guarantors fail to comply with certain obligations under the Senior Secured Notes Registration Rights Agreement, additional interest of up to 1.00% per annum will begin to accrue and be payable on the Senior Secured Notes. In October 2013, we received consents from holders ("Holders") of 99.7% of the aggregate principal amount of the Senior Secured Notes outstanding to amend, among other things, the terms of the Senior Secured Notes among the Company, The Bank of New York Mellon, as trustee and collateral agent (the "Trustee"), and the Guarantors. As a result, we entered into the Third Supplemental Indenture with the Trustee to amend the Senior Secured Notes 66 -------------------------------------------------------------------------------- Indenture to permit the purchase, redemption or repayment of the Convertible Notes at any price, including at a premium or at a discount from the face value thereof, with any available cash. In May 2014, we received consents from Holders of 98.5% of the aggregate principal amount of the Senior Secured Notes outstanding to amend the terms of the Senior Secured Notes Registration Rights Agreement. As a result, we entered into the First Amendment (the "Amendment") to the Senior Secured Notes Registration Rights Agreement. The Amendment (i) postponed the deadline by which the Company must use commercially reasonable efforts to prepare and file the Exchange Offer with the SEC, from June 5, 2014 to June 30, 2015, and (ii) postponed the deadline by which the Company must use commercially reasonable efforts to file with and have declared effective by the SEC a shelf registration statement to cover certain resales of the Senior Secured Notes, from June 5, 2014 to June 30, 2015. The Amendment also had the effect of postponing the date on which an additional interest, which constitutes liquidated damages and is the exclusive remedy available to Holders for failing to register the Senior Secured Notes, begins to accrue as a result of failing to consummate the Exchange Offer or have a shelf registration statement declared effective. Accordingly, the Company and the Guarantors no longer have any obligation to pay Holders additional interest as of June 5, 2014, even though the Company and the Guarantors did not prepare, file or have declared effective a registration statement or a shelf registration statement or consummate the Exchange Offer by such date. First Lien Credit Facility On July 1, 2013, KCG, as borrower, entered into a first lien senior secured credit agreement (the "Credit Agreement") with Jefferies Finance LLC and Goldman Sachs Bank USA. The Credit Agreement was in the amount of $535.0 million (the "First Lien Credit Facility"), all of which was drawn on July 1, 2013. The First Lien Credit Facility also provided for a future uncommitted incremental first lien senior secured revolving credit facility of up to $50.0 million, including letter of credit and swingline sub-facilities, on certain terms and conditions contained in the Credit Agreement. In 2013, we repaid $300.0 million of principal of the First Lien Credit Facility. A portion of the $300.0 million totaling $117.3 million was drawn from cash held in the Collateral Account and the remainder of the $300.0 million was paid out of available cash, including proceeds from the sale of Urban. In conjunction with these payments, we wrote down $13.2 million of our capitalized debt costs associated with the Credit Agreement. In the first half of 2014, we repaid the remaining $235.0 million of principal of the First Lien Credit Facility out of available cash and the Credit Agreement was terminated. In conjunction with these payments, we wrote down the remaining $9.6 million, of our capitalized debt costs associated with the Credit Agreement. The First Lien Credit Facility bore interest, at KCG's option, at a rate based on the prime rate ("First Lien Prime Rate Loans") or based on LIBOR ("First Lien Eurodollar Loans"). First Lien Prime Rate Loans bore interest at a rate per annum equal to the greatest of prime rate, 2.25%, the federal funds rate plus 0.50%, and an adjusted one-month LIBOR rate plus 1.00%, in each case plus an applicable margin of 3.50%. First Lien Eurodollar Loans bore interest at a rate per annum equal to the adjusted LIBOR rate (subject to a 1.25% LIBOR floor) corresponding to the interest period plus an applicable margin of 4.50% per annum. We incurred issuance costs of $38.5 million in connection with the issuance of Senior Secured Notes, Credit Agreement and consent solicitations. The remaining issuance costs are recorded within Other assets on the Consolidated Statements of Financial Condition and are amortized over the respective term of the Senior Secured Notes. Including issuance costs, the Senior Secured Notes had an effective yields of 9.1%. Revolving Credit Agreement On July 1, 2013, OCTEG, LLC ("OCTEG") and Knight Capital Americas LLC ("KCA"), wholly-owned broker dealer subsidiaries of KCG, as borrowers, and KCG, as guarantor, entered into a credit agreement (the "KCGA Facility Agreement") with a consortium of banks and financial institutions. The KCGA Facility Agreement replaces an existing credit agreement, dated as of June 6, 2012, among OCTEG and three banks. The KCGA Facility Agreement comprises two classes of revolving loans in a total committed amount of $450.0 million, together with a swingline facility with a $50.0 million sub-limit, subject to two borrowing bases (collectively, the "KCGA Revolving Facility"): Borrowing Base A and Borrowing Base B. The KCGA Revolving Facility also provides for a future increase of the revolving credit facility of up to $300.0 million to a total of $750.0 million on certain terms and conditions. 67 -------------------------------------------------------------------------------- The KCGA Revolving Facility was amended on October 24, 2013 to permit OCTEG to be removed as a borrower under the KCGA Revolving Facility. As of January 1, 2014, OCTEG was merged with and into KCA and KCA was renamed KCG Americas LLC ("KCGA"). Borrowings under the KCGA Revolving Facility bear interest, at the borrower's option, at a rate based on the federal funds rate ("Base Rate Loans") or based on LIBOR ("Eurodollar Loans"), in each case plus an applicable margin. For each Base Rate Loan, the interest rate per annum is equal to the greater of the federal funds rate or an adjusted one-month LIBOR rate plus (a) for each Borrowing Base A loan, a margin of 1.75% per annum and (b) for each Borrowing Base B loan, a margin of 2.25% per annum. For each Eurodollar Loan, the interest rate per annum is equal to an adjusted LIBOR rate corresponding to the interest period plus (a) for each Borrowing Base A loan, a margin of 1.75% per annum and (b) for each Borrowing Base B loan, a margin of 2.25% per annum. As of September 30, 2014, there were no outstanding borrowings under the KCGA Facility Agreement. The proceeds of the Borrowing Base A loans may be used solely to finance the purchase and settlement of securities. The proceeds of Borrowing Base B loans may be used solely to fund clearing deposits with the NSCC. The borrower is being charged a commitment fee at a rate of 0.35% per annum on the average daily amount of the unused portion of the KCGA Facility Agreement. The loans under the KCGA Facility Agreement will mature on June 6, 2015. The KCGA Revolving Facility is fully and unconditionally guaranteed on an unsecured basis by KCG and, to the extent elected by KCGA, any of their respective subsidiaries. It is secured by first-priority pledges of and liens on certain eligible securities, subject to applicable concentration limits, in the case of Borrowing Base A loans, and by first-priority pledges of and liens on the right to the return of certain eligible NSCC margin deposits, in the case of Borrowing Base B loans. The KCGA Facility Agreement includes customary affirmative and negative covenants, including limitations on indebtedness, liens, hedging agreements, investments, loans and advances, asset sales, mergers and acquisitions, dividends, transactions with affiliates, restrictions on subsidiaries, issuance of capital stock, negative pledges and business activities. It contains financial maintenance covenants establishing a minimum total regulatory capital for KCGA, a maximum total asset to total regulatory capital ratio for KCGA, a minimum excess net capital limit for KCGA, a minimum liquidity ratio for KCGA, and a minimum tangible net worth threshold for KCGA. As of September 30, 2014, the Company was in compliance with the covenants. In connection with the KCGA Revolving Facility, we incurred issuance costs of $1.2 million which is recorded within Other assets on the Consolidated Statements of Financial Condition and it is being amortized over the term of the facility. See Footnote 11 "Debt" included in Part I, Item 1 "Financial Statements (Unaudited)" of this Form 10-Q. Stock repurchase During the second quarter of 2014, the Company approved an initial program to repurchase up to a total of $150.0 million in shares of the Company's outstanding KCG Class A Common Stock and KCG Warrants. Through September 30, 2014, we had repurchased 8.1 million shares for $95.0 million under this program. As of September 30, 2014, we had $55.0 million available to repurchase additional shares under the program. We may repurchase shares from time to time in open market transactions, accelerated stock buyback programs, tender offers, privately negotiated transactions or by other means. Repurchases may also be made under Rule 10b5-1 plans. The timing and amount of repurchase transactions will be determined by our management based on its evaluation of market conditions, share price, legal requirements and other factors. The program may be suspended, modified or discontinued at any time without prior notice. We caution that there are no assurances that any further repurchases will actually occur. As of September 30, 2014 we had 117.2 million shares of KCG Class A Common Stock outstanding including RSUs. Regulatory requirements Our U.S. registered broker dealer is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker dealers and FCMs and require the maintenance of minimum levels of net capital, as defined in SEC Rule 15c3-1 as well as other capital requirements from several commodity organizations including the Commodity Futures Trading Commission ("CFTC") and the National Futures Association. These regulations also prohibit a broker dealer from repaying subordinated borrowings, paying cash dividends, making loans to its parent, affiliates or employees, or otherwise entering into transactions which would result in a reduction of its total net capital to less than 120% of its required minimum capital. Moreover, broker dealers are required to notify the SEC, CFTC and 68 -------------------------------------------------------------------------------- other regulators prior to repaying subordinated borrowings, paying dividends and making loans to its parent, affiliates or employees, or otherwise entering into transactions, which, if executed, would result in a reduction of 30% or more of its excess net capital (net capital less minimum requirement). The SEC and the CFTC have the ability to prohibit or restrict such transactions if the result is detrimental to the financial integrity of the broker dealer. As of September 30, 2014, our broker dealer was in compliance with the applicable regulatory net capital rules. The following table sets forth the net capital level and requirements for our regulated U.S. broker dealer subsidiary at September 30, 2014, as reported in its respective regulatory filing (in thousands): Net Capital Excess Net Entity Net Capital Requirement Capital KCG Americas LLC $ 290,349 $ 29,436 $ 260,913 As of January 1, 2014, OCTEG was merged into KCA as a result of consolidating our domestic broker dealers and KCA was subsequently renamed KCG Americas LLC. Our U.K. registered broker dealers are subject to certain financial resource requirements of Financial Conduct Authority ("FCA") while our Singapore and Australian broker dealers are subject to certain financial resource requirements of the Securities and Futures Commission and the Australian Securities and Investment Commission, respectively. The following table sets forth the financial resource requirement for the following foreign regulated broker dealers at September 30, 2014 (in thousands): Excess Financial Resource Financial Entity Resources Requirement Resources KCG Europe Limited $ 215,648 $ 167,843 $ 47,805 GETCO Europe Limited 10,868 3,253 7,615 The businesses of GETCO Europe Limited were combined into KCG Europe Limited in the second quarter of 2014 but the legal entity itself has not officially dissolved. We are in the process of withdrawing GETCO Europe Limited's membership with the FCA. Off-Balance Sheet Arrangements As of September 30, 2014, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. Effects of Inflation The majority of our assets are liquid in nature and therefore are not significantly affected by inflation. However, the rate of inflation may affect our expenses, such as employee compensation, office leasing costs and communications expenses, which may not be readily recoverable in the prices of the services offered by us. To the extent inflation results in rising interest rates and has other adverse effects on the securities markets, it may adversely affect our financial position and results of operations. Discontinued Operations & Assets and Liabilities Held for Sale In July 2013, we entered into an agreement to sell to an investor group our reverse mortgage origination securitization business, Urban, that was previously owned by Knight. The transaction completed in the fourth quarter of 2013 and residual expenses of Urban's operations and costs of the related sale have been reported in Loss from discontinued operations, net of tax on the Consolidated Statements of Operations for the three and nine months ended September 30, 2014. In September 2014, we entered into an agreement to sell certain assets and liabilities related to our FCM business to Wedbush Securities Inc. The FCM is a single disposal group held-for-sale as of September 30, 2014. We estimate that no write-down will be as required as the fair value of certain assets and liabilities related to the FCM less costs to sell will exceed the related carrying value. The transaction, which is subject to customary closing conditions and regulatory approvals, is expected to close in the fourth quarter of 2014, and, as a result, certain assets and liabilities related to the FCM business have been included in Assets held for sale and Liabilities held for sale on our Consolidated Statement of Condition as of September 30, 2014. 69 -------------------------------------------------------------------------------- Critical Accounting Policies Our Consolidated Financial Statements are based on the application of GAAP which requires us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and the accompanying notes. Future events and their effects cannot be determined with certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates and any such differences may be material to our Consolidated Financial Statements. We believe that the estimates set forth below may involve a higher degree of judgment and complexity in their application than our other accounting estimates and represent the critical accounting estimates used in the preparation of our consolidated financial statements. We believe our judgments related to these accounting estimates are appropriate. However, if different assumptions or conditions were to prevail, the results could be materially different from the amounts recorded. Financial Instruments and Fair Value-We value our financial instruments using a hierarchy of fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs when measuring fair value. The fair value hierarchy can be summarized as follows: • Level 1-Valuations based on quoted prices in active markets for identical assets or liabilities that we have the ability to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment. • Level 2-Valuations based on quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly. • Level 3-Valuations based on inputs that are unobservable and significant to the overall fair value measurement. Changes in fair value are recognized in earnings each period for financial instruments that are carried at fair value. Our financial instruments owned and financial instruments sold, not yet purchased will generally be classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices or broker or dealer quotations with reasonable levels of price transparency. The types of instruments that trade in markets that are not considered to be active, but are valued based on observable inputs such as quoted market prices or alternative pricing sources with reasonable levels of price transparency are generally classified within Level 2 of the fair value hierarchy. Our foreign currency forward contracts, investment in the Deephaven Funds and deferred compensation investments are also classified within Level 2 of the fair value hierarchy. We have no financial instruments classified within Level 3 of the fair value hierarchy. There were no transfers of financial instruments between levels of the fair value hierarchy for any periods presented. Goodwill and Intangible Assets-As a result of our various acquisitions, we have acquired goodwill and identifiable intangible assets. We determine the values and useful lives of intangible assets upon acquisition. Goodwill is the cost of acquired companies in excess of the fair value of net assets, including identifiable intangible assets, at the acquisition date. We test goodwill and intangible assets with an indefinite useful life for impairment at least annually or when an event occurs or circumstances change that signifies the existence of impairment. Goodwill Goodwill of $17.3 million at September 30, 2014 is primarily a result of the Mergers and primarily relates to our Market Making segment. We test the goodwill in each of our reporting units for impairment at least annually by comparing the estimated fair value of each reporting unit with its estimated net book value. We will derive the fair value of each of our reporting units based on valuation techniques we believe market participants would use for each segment (observable market multiples and discounted cash flow analyses) and we will derive the net book value of our reporting units by estimating the amount of stockholders' equity required to support the activities of each reporting unit. As part of our test for impairment, we will also consider the profitability of the applicable reporting unit as well as our overall market value, compared to our book value. No events occurred during the quarter ended September 30, 2014 that would indicate that our goodwill may not be recoverable. 70 -------------------------------------------------------------------------------- Intangible Assets Intangible assets, less accumulated amortization, of $173.3 million at September 30, 2014 are primarily a result of the Mergers and are primarily attributable to our Market Making and Global Execution Services segments. We amortize intangible assets with definite lives on a straight-line basis over their useful lives, the majority of which have been determined to range from one to 10 years. We will test amortizable intangibles for recoverability whenever events indicate that the carrying amounts may not be recoverable. No events occurred during the quarter ended September 30, 2014 that would indicate that the carrying amounts of our intangible assets may not be recoverable. Investments-Investments primarily comprise strategic investments and deferred compensation investments. Strategic investments include noncontrolling equity ownership interests in financial services-related businesses held by us within our non-broker dealer subsidiaries. Strategic investments are accounted for under the equity method, at cost or at fair value. We use the equity method of accounting when we have significant influence, generally considered to be between 20% and 50% equity ownership or greater than 3% to 5% of a partnership interest. We hold strategic investments at cost, less impairment if any, when we are not considered to exert significant influence on operating and financial policies of the investee. Strategic investments with a readily determinable fair value are held at fair value. We review investments on an ongoing basis to ensure that the carrying values of the investments have not been impaired. If we assess that an impairment loss on a strategic investment has occurred due to a decline in fair value or other market conditions, we write the investment down to its estimated impaired value. We maintain a deferred compensation plan related to certain employees and directors. This plan provides a return to the participants based upon the performance of various investments. In order to hedge our liability under this plan, we generally acquire the underlying investments and hold such investments until the deferred compensation liabilities are satisfied. We record changes in value of such investments in Investment income and other, net, with a corresponding charge or credit to Employee compensation and benefits on the Consolidated Statements of Operations. Market Making, Sales, Trading and Execution Activities-Financial instruments owned and Financial instruments sold, not yet purchased, which relate to market making and trading activities, include listed and other equity securities, listed equity options and fixed income securities which are recorded on a trade date basis and carried at fair value. Trading revenues, net (trading gains, net of trading losses) and commissions (which includes commission equivalents earned on institutional client orders and futures transactions) and related expenses are also recorded on a trade date basis. Our third party clearing agreements call for payment or receipt of interest income, net of transaction-related interest charged by clearing brokers for facilitating the settlement and financing of securities transactions. Dividend income relating to securities owned and dividend expense relating to securities sold, not yet purchased, derived from our market making activities are included as a component of Trading revenues, net on our Consolidated Statements of Operations. Lease Loss Accrual-It is our policy to identify excess real estate capacity and where applicable, accrue for related future costs, net of estimated sublease income. In the event we are able to sublease the excess real estate after recording a lease loss, such accrual is adjusted to the extent the actual terms of sub-leased property differ from the assumptions used in the calculation of the accrual. In the event that we conclude that previously determined excess real estate is needed for our use, such lease loss accrual is adjusted accordingly. Any such adjustments to previous lease loss accruals are recorded in Writedown of assets and lease loss accrual, net on the Consolidated Statements of Operations Income taxes-Prior to the Mergers, GETCO and the majority of its subsidiaries were treated as partnerships or disregarded entities for U.S. income tax purposes and, accordingly, were not subject to federal income taxes. Instead, the former GETCO members were liable for federal income taxes on their proportionate share of taxable income. Upon completion of the Mergers, the Company became a corporation subject to U.S. corporate income taxes and, following the Mergers, the Company records deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities and measures them using the enacted tax rates and laws that will be in effect when such differences are expected to reverse. The Company evaluates the recoverability of future tax deductions by assessing the adequacy of future expected taxable income from all sources, including reversal of temporary differences and forecasted operating earnings. Other Estimates-The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. In addition to the estimates that we make in connection with accounting for 71 -------------------------------------------------------------------------------- the items noted above, the use of estimates is also important in determining provisions for potential losses that may arise from discontinued operations, litigation, regulatory proceedings and tax audits. When determining stock-based employee compensation expense, we make certain estimates and assumptions relating to volatility and forfeiture rates. We estimate volatility based on several factors including implied volatility of market-traded options on our common stock on the grant date and the historical volatility of our common stock. We estimate forfeiture rates based on historical rates of forfeiture of employee stock awards. A portion of our Employee compensation and benefits expense on the Consolidated Statements of Operations represents discretionary bonuses, which are accrued for throughout the year and paid after the end of the year. Among many factors, discretionary bonus accruals are generally influenced by our overall performance and competitive industry compensation levels. We accrue for potential losses that may arise out of litigation and regulatory proceedings to the extent that such losses are probable and can be estimated. Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total liability accrued with respect to litigation and regulatory proceedings is determined on a case-by-case basis and represents an estimate of probable losses based on, among other factors, the progress of each case, our experience and industry experience with similar cases and the opinions and views of internal and external legal counsel. Given the inherent difficulty of predicting the outcome of our litigation and regulatory matters, particularly in cases or proceedings in which substantial or indeterminate damages or fines are sought, or where cases or proceedings are in the early stages, we cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred. For more information on our legal and regulatory matters, see Footnote 19 "Commitments and Contingent Liabilities" included in Part I, Item 1 "Financial Statements (Unaudited)" of this Form 10-Q and other reports or documents the Company files with, or furnishes, to the SEC from time to time. Change in accounting principle During the first quarter of 2014 the Company changed its method of accounting for its investment in BATS following the merger of BATS and Direct Edge. As a result of the change in accounting principle, the Consolidated Statement of Financial Condition at December 31, 2013 has been adjusted as follows: Investments increased by approximately $3.4 million, Deferred tax asset, net decreased by $1.1 million and Retained earnings increased by $2.3 million. The Consolidated Statements of Operations for the three and nine months ended September 30, 2013 have been adjusted by an increase in Investment income and other, net by $1.5 million and $5.8 million, respectively. During the first quarter of 2014 the Company recognized income of $9.6 million related to the merger of BATS and Direct Edge which is recorded within Investment income and other, net in the Consolidated Statements of Operations. The $9.6 million comprises a partial realized gain with respect to the Company's investment in Direct Edge of $16.2 million offset, in part, by the Company's share of BATS' and Direct Edge's merger related transaction costs that were charged against their respective earnings of $6.6 million. See Footnote 9 "Investments" and Footnote 3 "Significant Accounting Policies" included in Part I, Item 1 "Financial Statements (Unaudited)" of this Form 10-Q for further discussion. Accounting Standards Updates Recently adopted accounting guidance In March 2013, the Financial Accounting Standards Board ("FASB") issued an Accounting Standard Update ("ASU") concerning the parent's accounting for the cumulative translation adjustment upon derecognition of certain subsidiaries or groups of assets within a foreign entity or of an investment in a foreign entity. This ASU provides for the release of the cumulative translation adjustment into net income when a parent sells a part or all of its investment within a foreign entity, no longer holds a controlling interest in an investment in a foreign entity or obtains control of an investment in a foreign entity that was previously recognized as an equity method investment. This ASU was effective for reporting periods beginning after December 15, 2013. The adoption of this ASU did not have an impact on our Consolidated Financial Statements. In July 2013, the FASB issued an ASU to clarify the financial statement presentation of an unrecognized tax benefit when a net operating loss ("NOL") carryforward, a similar tax loss, or a tax credit carryforward exists. This ASU requires entities to present an unrecognized tax benefit as a reduction of a deferred tax asset for a NOL carryforward 72 -------------------------------------------------------------------------------- whenever the NOL or tax credit carryforward would be available to reduce the additional taxable income or tax due if the tax position is disallowed. The ASU is required for reporting periods beginning after December 15, 2013. The adoption of this ASU did not have an impact on our Consolidated Financial Statements. In April 2014, the FASB issued an ASU that amends the requirements for reporting discontinued operations. Under the new guidance, discontinued operations reporting will be limited to disposal transactions that represent strategic shifts having a major effect on operations and financial results. The amended guidance also enhances disclosures and requires assets and liabilities of a discontinued operation to be classified as such for all periods presented in the financial statements. The updated guidance is effective prospectively to all disposals occurring for interim and annual reporting periods after December 15, 2014, with early adoption permitted. We early adopted this ASU in 2014. The adoption of this ASU resulted in additional disclosures within our Consolidated Financial Statements. Recent accounting guidance to be adopted in future periods In May 2014, the FASB issued an ASU that updates the principles for recognizing revenue. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The updated guidance is effective for interim and annual reporting periods beginning after December 15, 2016. Early adoption is not permitted. We are evaluating the impact of this ASU on our Consolidated Financial Statements. In June 2014, the FASB issued an ASU to resolve diverse accounting treatment for share based awards in which the terms of the award are related to a performance target that affects vesting. The ASU requires an entity to treat a performance target that could be achieved after the requisite service period as a performance condition. Additionally, compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved, and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered; if the performance target becomes probable of being achieved before the end of the requisite service period, then the remaining unrecognized compensation cost should be recognized prospectively over the remaining requisite service period. The guidance is effective for reporting periods beginning after December 15, 2015 and may be applied prospectively or retrospectively. We do not expect adoption of this ASU to have an impact on our Consolidated Financial Statements. In June 2014, the FASB issued an ASU that amends the accounting and disclosure guidance on repurchase agreements. The amended guidance requires entities to account for repurchase-to-maturity transactions as secured borrowings. Additional disclosures will be required for the nature of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. The guidance is effective for reporting periods beginning after December 15, 2014. Early adoption is not permitted. We are evaluating the impact of this ASU on our Consolidated Financial Statements. In August 2014, the FASB issued an ASU that requires an entity's management to evaluate whether there are conditions or events that raise substantial doubt about the entity's ability to continue as a going concern within one year after the date that the financial statements are issued. The guidance is effective for reporting periods beginning after December 15, 2016. Other than additional disclosure requirements, the adoption of this ASU is not expected to have an impact on our Consolidated Financial Statements. 73-------------------------------------------------------------------------------- |