10Q FILED - KNIGHT CAPITAL GROUP, INC. - Managemen

10Q FILED - KNIGHT CAPITAL GROUP, INC. - Management's Discussion and Analysis of Financial Condition and Results of Operations Edgar Thursday, August 09 2012 2:05 PM, EST

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The following discussion of our results of operations should be read in conjunction with our Consolidated Financial Statements and notes included in Current Report on Form 8-K dated August 6, 2012 as filed with the U.S. Securities and Exchange Commission ("SEC"). This discussion contains forward-looking statements that involve risks and uncertainties, including those discussed in our Form 10-K for the year ended December 31, 2011 and herein. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth elsewhere in this document and in our Form 10- K. 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, may constitute forward-looking statements. 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 our control. 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 the August 1, 2012 technology issue that resulted in the Company sending numerous erroneous orders in NYSE -listed and NYSE Arca securities into the market and the impact to the Company's capital structure and business as well as actions taken in response thereto and consequences thereof, risks associated with the Company's ability to recover all or a portion of the damages that are attributable to the manner in which NASDAQ OMX handled the Facebook IPO, risks associated with changes in market structure, legislative, regulatory or financial reporting rules, risks associated with the Company's changes to its organizational structure and management and the costs, integration, performance and operation of businesses previously acquired or developed organically, or that may be acquired or developed organically in the future. 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" within MD&A herein and under "Risk Factors" herein and in the Company's Annual Report on Form 10-K for the year ended December 31, 2011 and in other reports or documents the Company files with, or furnishes to, the SEC from time to time. This information should also be read in conjunction with the Company's Consolidated Financial Statements and the Notes thereto contained in this 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 global financial services firm that provides access to the capital markets across multiple asset classes to a broad network of clients, including broker-dealers, institutions and corporations. We seek to continually apply our expertise and innovation to the market making and trading process to build lasting client relationships through consistent performance and superior client service. We also provide capital markets services to corporate issuers and private companies. We have four operating segments: (i) Market Making; (ii) Institutional Sales and Trading ; (iii) Electronic Execution Services; and (iv) Corporate and Other.

Market Making - Our Market Making segment principally consists of market

making in global equities and listed domestic options. As a market maker,

we commit capital for trade executions by offering to buy securities from,

or sell securities to, institutions and broker-dealers. Our Market Making

segment primarily includes client, and to a lesser extent, non-client

electronic market making activities in which we operate as a market maker

in equity 42

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securities quoted and traded on the Nasdaq Stock Market , the

over-the-counter ("OTC") market for New York Stock Exchange ("NYSE"), NYSE

Amex Equities ("NYSE Amex"), NYSE Arca listed securities and several

European exchanges. As a complement to electronic market making, our cash

trading business handles specialized orders and also transacts on the OTC

Bulletin Board, the OTC Pink Markets, and the Alternative Investment

Market ("AIM") of the London Stock Exchange . We provide trade executions

as an equities Designated Market Maker ("DMM") on the NYSE and NYSE Amex.

Market Making also includes our option market making business which trades

on substantially all domestic electronic exchanges. Institutional Sales and Trading - Our Institutional Sales and Trading segment includes global equity, exchange traded fund ("ETF") and fixed income sales; reverse mortgage origination and securitization; capital markets; and asset management activities. The primary business of the

Institutional Sales and Trading segment is to execute and facilitate

equities, ETFs, and fixed income transactions as agent on behalf of

institutional clients, and we commit capital on behalf of our clients when

needed. This is predominantly a full-service execution business, in which

much of the interaction is based on the Company's client relationships.

This segment also facilitates client orders through program and block trades and riskless principal trades and provides capital markets services, including equity and debt private placement.

Electronic Execution Services - Our Electronic Execution Services segment

offers access via our electronic agency-based platforms to markets and

self-directed trading in equities, options, fixed income, foreign exchange

and futures. In contrast to Market Making, we generally do not act as a principal to transactions that are executed within this segment and

generally earn commissions for acting as agent between the principals to

the trade. Corporate and Other - Our Corporate and Other segment invests 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. The

Corporate and Other segment houses functions that support our other segments such as self-clearing services, including securities lending activities. Beginning in the second quarter of 2012, our Corporate and Other segment includes our futures commission merchant ("FCM") which comprises certain assets and liabilities which we acquired from the

futures division of Penson Financial Services, Inc. on June 1, 2012 . This

business provides futures execution, clearing and custody services to

facilitate transactions among brokers, institutions and non-clearing FCMs

on major U.S. and European futures and options exchanges, and also offers

risk management and consultation services and operates an electronic

futures trading platform for professional traders and individual investors. 43

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The following table sets forth: (i) Revenues; (ii) Expenses; and (iii) Pre-tax earnings or loss from our segments and on a consolidated basis (in millions):

For the three months ended For the six months ended June 30, June 30, 2012 2011(1) 2012 2011(1) Market Making Revenues $ 113.5 $ 145.0 $ 265.7 $ 312.2 Expenses 107.6 105.9 214.6 209.7 Pre-tax earnings 5.9 39.2 51.1 102.5 Institutional Sales and Trading Revenues 109.7 134.9 251.9 262.3 Expenses 117.2 138.9 244.8 273.9 Pre-tax (loss) earnings (7.5 ) (4.0 ) 7.2 (11.7 ) Electronic Execution Services Revenues 43.3 41.9 87.5 82.3 Expenses 31.9 30.1 63.9 59.1 Pre-tax earnings 11.3 11.8 23.6 23.2 Corporate and Other Revenues 22.8 4.1 33.2 9.0 Expenses 27.2 21.7 55.7 43.5 Pre-tax (loss) (4.4 ) (17.6 ) (22.5 ) (34.5 ) Consolidated Revenues 289.3 326.0 638.3 665.8 Expenses 283.9 296.5 578.9 586.2 Pre-tax earnings $ 5.4 $ 29.5 $ 59.4 $ 79.5

* Totals may not add due to rounding.

(1) - Prior period amounts have been recast to conform to current period segment

presentation. Such recast had no effect on previously reported consolidated

pre-tax earnings.

Consolidated revenues for the three months ended June 30, 2012 decreased $36.7 million , or 11.3%, from the same period a year ago, while consolidated expenses decreased $12.6 million , or 4.3%. Consolidated pre-tax earnings for the three months ended June 30, 2012 decreased $24.1 million , or 81.8%, from the same period a year ago. Consolidated revenues for the six months ended June 30, 2012 decreased $27.5 million , or 4.1%, from the same period a year ago, while consolidated expenses decreased $7.3 million , or 1.2%. Consolidated pre-tax earnings for the six months ended June 30, 2012 decreased $20.2 million , or 25.4%, from the same period a year ago.

Consolidated revenues for the three and six months ended June 30, 2012 include an aggregate $35.4 million trading loss related to the Facebook IPO, which primarily impacted our Market Making and Institutional Sales and Trading segments.

On July 18, 2012 , we announced pre-tax trading losses of $35.4 million related to the Facebook IPO. On July 21, 2012 , NASDAQ announced that it would file a proposed voluntary accommodation program (the "Accommodation Program") with the SEC which, among other things, creates a fund for voluntary accommodations for qualifying NASDAQ members disadvantaged by problems that arose 44

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during the Facebook IPO. The Accommodation Program, which was published in the Federal Register by the SEC on August 1, 2012 , will be subject to a 21 day public comment period and thereafter approval by the SEC . Under the proposed Accommodation Program, we would be entitled to submit claims, within seven days of formal approval by the SEC , in accordance with the parameters set forth in the Accommodation Plan. The claims would be processed and evaluated by the Financial Industry Regulatory Authority ("FINRA") applying the accommodation standards set forth in the Accommodation Program. Under the Accommodation Program as proposed by NASDAQ, we would recover a portion of our pre-tax trading losses. We are evaluating the Accommodation Program as well as our other options, and plan to submit a comment letter to the SEC . There can be no assurance that the Accommodation Program will be approved by the SEC or that the terms of the Accommodation Program will not change from those proposed. As previously disclosed, there are no assurances that we will be able to recover our pre-tax trading losses relating to the Facebook IPO.

The changes in our pre-tax earnings (loss) by segment from the three and six months ended June 30, 2011 are summarized as follows:

Market Making - Our pre-tax earnings from Market Making for the three

months ended June 30, 2012 decreased by $33.2 million , or 84.9%, from the

comparable period in 2011. Our pre-tax earnings from Market Making for the

six months ended June 30, 2012 decreased by $51.5 million , or 50.2%, from

the comparable period in 2011. The quarter over quarter and year over year

decrease is primarily due to a $26.0 million trading loss related to the

Facebook IPO and a decrease in volumes resulting in lower revenues from

both our client and non-client quantitative trading models, offset, in

part, by higher average revenue capture per U.S. equity Market Making

dollar value traded, excluding the impact of Facebook IPO.

Institutional Sales and Trading - Our pre-tax loss from Institutional

Sales and Trading for the three months ended June 30, 2012 increased by

$3.5 million from the comparable period in 2011. The quarter over quarter

increased loss is primarily due to a $9.4 million trading loss related to

the Facebook IPO and lower revenues and pre-tax results from our capital

markets and reverse mortgage businesses offset, in part, by a decrease in

guaranteed compensation in our fixed income business and improved results

from our listed derivatives business. Our pre-tax earnings from

Institutional Sales and Trading for the six months ended June 30, 2012

increased by $18.8 million , from a loss in the comparable period in 2011.

The year over year increase is primarily due to increased earnings from our fixed income business, including our reverse mortgage business and

listed derivatives business, offset, in part, by a trading loss related to

the Facebook IPO and lower revenues from our capital markets business.

Electronic Execution Services - Our pre-tax earnings from Electronic

Execution Services for the three months ended June 30, 2012 decreased by

$0.5 million , or 3.9%, from the comparable period in 2011. The quarter

over quarter decrease is primarily due to higher compensation expense,

offset, in part, by higher earnings from increased volumes in our Knight

Direct business. Our pre-tax earnings from Electronic Execution Services

for the six months ended June 30, 2012 increased by $0.4 million , or 1.9%,

from the comparable period in 2011. The year over year increase is

primarily due to higher earnings from increased volumes in our Knight

Direct business offset, in part, by decreased volumes in our Knight

Hotspot FX business. Corporate and Other - Our pre-tax loss from our Corporate and Other

segment for the three months ended June 30, 2012 decreased by $13.1

million from the comparable period in 2011 and our pre-tax loss for the

six months ended June 30, 2012 decreased by $12.0 million from the comparable period in 2011. The decrease in loss for both periods is primarily due to a $10.0 million gain related to a change in the tax status of a strategic investment accounted for 45

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under the equity method of accounting, offset, in part, by higher interest

expense related to our long-term debt and securities lending activity for

the three and six months ended June 30, 2012 .

Subsequent Event

We experienced a technology issue at the open of trading at the NYSE on August 1, 2012 . This issue was related to the installation that day of trading software and resulted in us sending numerous erroneous orders in NYSE -listed and NYSE Arca securities into the market. Although this software was subsequently removed from our systems and clients were not negatively affected by the erroneous orders, it resulted in us realizing a pre-tax loss of approximately $440.0 million . This event severely impacted our capital base and business operations, and we experienced reduced order flow, liquidity pressures and harm to customer and counterparty confidence. As a result, there was substantial doubt about our ability to continue as a going concern. Following the event of August 1, 2012 , we have begun an internal review into such event and associated controls. In light of this event, on August 6, 2012 , after evaluating and pursuing various strategic alternatives, we sold 400,000 shares of convertible preferred stock in private placements to investors in exchange for aggregate cash consideration of $400.0 million . The preferred stock consisted of 79,600 shares of Series A-1 preferred stock and 320,400 shares of Series A-2 preferred stock. The Series A-1 preferred stock and Series A-2 preferred stock are convertible into approximately 266.7 million shares of Class A common stock, or approximately 73% of the total number of shares of Class A common stock outstanding as of August 3, 2012 , assuming the conversion in full of the preferred stock into Class A common stock. Although our capital base was severely impacted as a result of the event, our regulated broker-dealer subsidiaries remained in full compliance with their net capital requirements at all times. In addition, we remain in good standing with The Depository Trust & Clearing Corporation's depository and clearing subsidiaries as well as the OCC. As of the close of business on August 6, 2012 , Knight Capital Americas LLC , our domestic broker-dealer subsidiary, had excess net capital greater than $300.0 million .

Certain Factors Affecting Results of Operations

We may experience significant variation in our future results of operations. These fluctuations may result from numerous factors, including, among other things, market conditions and the resulting volatility, credit and counterparty risks that may result; introductions of, or enhancements to, trade execution services by us or our competitors; the value of our securities positions and other financial instruments and our ability to manage the risks attendant thereto; the volume of our trade execution activities; the dollar value of securities and other instruments traded; the composition and profile of our order flow; our market share with institutional and broker-dealer clients; the performance and size of, and volatility in, our client market making and program trading portfolios; the performance of our non-client principal trading activities; movements of credit spreads; home equity conversion mortgages ("HECMs") origination and HECM Mortgage Backed Securities ("HMBS") securitization volumes; the overall size of our balance sheet and capital usage; the potential impairment of goodwill and/or intangible assets; the performance of our global operations, trading technology and trading infrastructure; costs associated with overall business growth; the effectiveness of our self-clearing and futures platforms and our ability to manage risk related thereto; the availability of credit and liquidity in the marketplace; erroneous trade orders submitted by us on account of technology or other issues (such as occurred on August 1, 2012 ) and consequences thereof; the performance, operation and connectivity to various market centers; our ability to manage personnel, compensation, overhead and other expenses; 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 46

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movements; the addition or loss of executive management, sales, trading and technology professionals; legislative, legal, regulatory and financial reporting changes; legal, regulatory matters or proceedings; geopolitical risk; the amount, timing and cost of capital expenditures, acquisitions and divestitures; the integration, performance and operation of acquired businesses; the incurrence of costs associated with acquisitions and dispositions; investor sentiment; technological changes and events; seasonality; competition; and other economic conditions. 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 our four operating segments. 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 the rates of revenue growth 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 the quarter ended June 30, 2012 , volatility levels across equity markets were relatively stable as compared to the previous quarter, while in the debt markets, credit spreads widened. Secondary trading volumes in the equity and fixed income markets were down from prior periods. 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 have increased the level of sophistication and

automation within their operations and the extent of price improvement.

The greater 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, Institutional Sales and Trading and Electronic 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, Institutional

Sales and Trading and Electronic 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 alternative trading systems ("ATS"),

ECN and other execution 47

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venues which compete within the OTC and listed trading venues. For

example, on July 3, 2012 , the SEC approved proposed rules submitted by the

NYSE and NYSE Amex to establish a Retail Liquidity Program ("RLP") on a

pilot basis for one year. The RLP seeks to attract retail flow to the NYSE

and NYSE Amex. This new program (as well as any similar program

established by other national stock exchanges) could draw market share

away from Knight, 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 are offering their

own internal crossing networks. These factors continue to create further

fragmentation and competition in the marketplace. Over the past few years, 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, as evidenced by increased volumes over the past few years in direct market access platforms, algorithmic and program trading, high frequency trading and

ECNs 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

also led to a dramatic increase in electronic message traffic. These increases in message traffic place heavy strains on the technology resources, bandwidth and capacities of market participants.

There has been continued scrutiny of the capital markets industry by the

regulatory and legislative authorities, both in the U.S. and abroad. New

legislation or new or modified regulations and rules could occur in the

future. Members of the U.S. Congress have asked the SEC and other

regulators to take a close look at the 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 have stated that they will propose and adopt rules where

necessary, on a variety of marketplace issues - including, but not limited

to: high frequency trading, indications of interest, off-exchange trading,

dark liquidity pools, internalization, post-trade attribution,

co-location, sponsored access, short sales, consolidated audit trails and

market volatility rules (including, circuit breakers and limit-up, limit-down rules).

We expect increases, possibly substantial, in Section 31 fees and fees

imposed by other regulators. In addition, DTCC and NSCC are considering

proposals which could require substantial increases in clearing margin 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.

Reverse mortgages can be a cost-effective way to help seniors (age 62 and

older) meet their financial needs in retirement, by enabling them to tap

the equity in their home. Reverse mortgages have been popular with seniors

who have equity in their homes and want to supplement their income and

enhance their liquidity. This popularity may continue as the Baby Boomer

generation enters retirement age. However, there is no guarantee that current volumes or the referenced popularity will continue. 48

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In 2011, two of the largest reverse mortgage originators exited the

reverse mortgage business. Declining home values and the inability to

assess borrowers' financial health were cited as factors contributing to

their respective decisions. In 2012, the largest reverse mortgage lender also exited the reverse mortgage business citing its focus on other business lines.

In January 2011 , the U.S. Department of Housing and Urban Development

("HUD") provided loss mitigation guidance for the resolution of HECMs that

are delinquent due to, among other things, unpaid property charges

(including taxes and homeowners insurance). HUD also discussed what steps

lenders could take to get mortgagors back on track (e.g., establishing a

repayment plan). HUD noted that foreclosure is and must remain a method of

last resort for the resolution of unpaid property charges. It has also

been reported that HUD is developing procedures that would allow lenders

to assess a prospective borrower's income and expenses, and possibly

require homeowners to set aside money to pay for taxes and homeowners

insurance. However, no formal guidelines have yet been published.

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 Commissions and fees and Net trading revenue from all of our business segments.

Revenues on transactions for which we charge explicit commissions or commission equivalents, which include the majority of our institutional client orders, commissions on futures transactions, as well as the mark-to-market of securitized HECM loan inventory, are included within Commissions and fees. Commissions and fees are primarily affected by changes in our equity, fixed income, futures and foreign exchange transaction volumes with institutional clients, changes in commission rates, level of volume based fees from providing liquidity to other trading venues, loan origination and securitization volume and spreads, assets under management and the level of our soft dollar and commission recapture activity. Trading profits and losses on principal transactions primarily relate to our global market making activities and are included within Net trading revenue. 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, 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 non-client trading models, volatility in the marketplace, our mix of broker-dealer and institutional clients, regulatory changes and evolving industry customs and practices. Interest income, 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, carry interest on loans and bonds held, and interest income net of interest expense on securitized HECM loan inventory. 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, the extent of our collateralized financing arrangements and the level of securitized HECM loan inventory. 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 and changes in value of certain deferred compensation investments. 49

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Expenses

Employee compensation and benefits expense, our largest expense, primarily consists of salaries and wages paid to all employees, profitability-based compensation, which includes compensation paid to sales personnel and incentive compensation paid to all other employees based on our profitability, employee benefits, and changes in value of certain deferred compensation liabilities. Employee compensation and benefits expense fluctuates, for the most part, based on changes in our revenues and business mix, profitability and the number of employees. Compensation for 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; execution fees paid to third parties, primarily for executing trades on the NYSE , other exchanges and ECNs; and loan processing fees. 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 and loan origination volume.

Communications and data processing expense primarily consists of costs for obtaining market data, connectivity, telecommunications services 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 also include fees paid to third party brokers with respect to reverse mortgage wholesale loan production and 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, reverse mortgage loan production and channel mix, our profitability and the mix of market orders, limit orders, and customer mix. Interest expense consists primarily of costs associated with our long-term debt and for collateralized financing arrangements such as securities lending and sale of financial instruments under our agreements to repurchase. 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 purchased software, capitalized software development costs and acquired 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.

Occupancy and equipment rentals consist primarily of rent and utilities related to leased premises and office equipment.

Business development consists primarily of costs related to sales and marketing, advertising, conferences and relationship management.

Professional fees consist primarily of legal, accounting and consulting fees.

Writedown of assets and lease loss accrual consist primarily of costs associated with the writedown of assets and lease losses related to excess office space.

Other expenses include regulatory fees, corporate insurance, employment fees, partial month interest reserves associated with our Government National Mortgage Association ("GNMA") issuances, and general office expense. 50

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Three Months Ended June 30, 2012 and 2011

Revenues Market Making For the three months ended June 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 23.0 $ 27.5 $ (4.5 ) -16.2 % Net trading revenue (millions) 91.9 115.7 (23.8 ) -20.5 % Interest, net (millions) (1.5 ) 1.9 (3.3 ) N/M Total Revenues from Market Making (millions) $ 113.5 $ 145.0 $ (31.5 ) -21.8 % U.S. equity Market Making statistics: Average daily dollar value traded ($ billions)* 20.9 23.4 (2.4 ) -10.3 % Average daily trades (thousands)* 3,303.1 3,253.8 49.3 1.5 % Nasdaq and Listed shares traded (billions)* 45.7 48.4 (2.7 ) -5.7 % FINRA OTC Bulletin Board and Other shares traded (billions)* 166.9 261.8 (94.9 ) -36.3 % Average revenue capture per U.S. equity dollar value traded (bps)* 0.80 0.93 (0.13 ) -13.5 % Average revenue capture per U.S. equity dollar value traded, excluding impact of Facebook IPO (bps)** 1.00 0.93 0.07 7.5 %

* Represents new presentation for U.S. equity Market Making for all periods

presented as described more fully in text below.

** Statistic excludes $26.0 million in trading losses related to the Facebook

IPO.

Totals may not add due to rounding.

N/M - Not meaningful

Total revenues from the Market Making segment, which primarily comprises Net trading revenue from our domestic businesses, decreased 21.8% to $113.5 million for the three months ended June 30, 2012 , from $145.0 million for the comparable period in 2011. Revenues for the three months ended June 30, 2012 were negatively impacted by $26.0 million of trading losses related to the Facebook IPO and lower volumes, which resulted in a decrease in revenues from both our client and non-client quantitative trading models offset, in part, by slightly higher average revenue capture per U.S. equity dollar value traded, excluding the impact of Facebook IPO. In the first quarter of 2012, we modified our quarterly revenue capture and monthly equity volume statistics in order to provide data specific to the U.S. equity market making activity within the Market Making segment. Our revenue capture and volume statistics previously also included U.S. institutional sales activity. Average revenue capture per U.S. equity dollar value traded was 0.80 basis points ("bps") for the second quarter of 2012, down 13.5% from the second quarter of 2011. Excluding the impact of the Facebook IPO, average revenue capture per U.S. equity dollar value traded was 1.0 bps for the second quarter of 2012, up 7.5% from the second quarter of 2011. Excluding the impact of the Facebook IPO, the primary driver for the slight increase in revenue capture was due in part to growth and enhancements to our trading models and infrastructure. 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), less certain transaction-related regulatory fees (included in Execution and clearance fees) (collectively "Domestic U.S. Equity Market Making Revenues"), divided by the total 51

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dollar value of the related equity transactions. Domestic U.S. Equity Market Making Revenues were $106.1 million , $132.1 million excluding the impact of Facebook IPO, and $136.8 million for the three months ended June 30, 2012 and 2011, respectively.

Institutional Sales and Trading

For the three months ended June 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 105.9 $ 125.7 $ (19.9 ) -15.8 % Net trading revenue (millions) 4.9 10.4 (5.4 ) -52.4 % Interest, net (millions) (1.3 ) (2.8 ) 1.5 53.0 % Investment income and other, net (millions) 0.2 1.6 (1.4 ) -85.5 % Total Revenues from Institutional Sales and Trading (millions) $ 109.7 $ 134.9 $ (25.2 ) -18.7 %

Totals may not add due to rounding.

Total revenues from the Institutional Sales and Trading segment, which primarily comprises Commissions and fees from institutional equities, ETFs, fixed income sales and reverse mortgage originations, decreased 18.7% to $109.7 million for the three months ended June 30, 2012 , from $134.9 million for the comparable period in 2011. Revenues were negatively impacted by $9.4 million of trading losses related to the Facebook IPO and lower revenues from our capital markets and reverse mortgage businesses offset, in part, by higher revenues from our listed derivatives business. Electronic Execution Services For the three months ended June 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 43.2 $ 42.3 $ 0.9 2.1 % Investment income and other, net (millions) 0.0 (0.4 ) 0.4 N/M Total Revenues from Electronic Execution Services (millions) $ 43.3 $ 41.9 $ 1.3 3.2 % Average daily Knight Direct equity shares (millions) 218.8 162.2 56.6 34.9 % Average daily Knight Hotspot FX notional dollar value traded ($ billions)* 28.1 31.5 (3.3 ) -10.6 %

* In the second quarter of 2012, we modified the reporting of Knight Hotspot FX

notional dollar value traded volume to count one side of the transaction. We

previously counted total client volume to include both sides of the

transaction.

Totals may not add due to rounding.

N/M - Not meaningful

Total revenues from the Electronic Execution Services segment, which primarily comprises Commissions and fees from agency execution activity, increased 3.2% to $43.3 million for the three months ended June 30, 2012 , from $41.9 million for the comparable period in 2011. Revenues were positively impacted by higher volumes from our Knight Direct and Knight BondPoint businesses. 52

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Table of Contents Corporate and Other For the three months ended June 30, 2012 2011 Change % of Change Total Revenues from Corporate and Other (millions) $ 22.8 $ 4.1 $ 18.7 451.8 % Total revenues from the Corporate and Other segment, which primarily represent interest income from our securities borrowing activity, gains or losses on strategic investments, and deferred compensation investments related to certain employees and directors, increased to $22.8 million for the three months ended June 30, 2012 , from $4.1 million for the comparable period in 2011. The primary drivers for the increase in revenues were a $10.0 million gain from a strategic investment that we account for under the equity method of accounting, offset, in part, by higher interest expense related to our long-term debt and securities lending activity. This investment gain was due to an income tax benefit recognized by the investee that arose from a change in its tax status during 2010, but which was reported and disclosed to us in the second quarter of 2012. The $10.0 million gain that we recorded in the second quarter of 2012 represents our share of the investee's net income which we recorded under the equity method of accounting. Expenses Employee compensation and benefits expense decreased to $130.9 million for the three months ended June 30, 2012 from $140.1 million for the comparable period in 2011. As a percentage of total revenue, Employee compensation and benefits increased to 45.2% for the three months ended June 30, 2012 , from 43.0% for the comparable period in 2011. The decrease on a dollar basis was primarily due to an overall decrease and change in the mix of our revenues across businesses and a decrease in guaranteed compensation from our Institutional Sales and Trading segment. The increase as a percentage of revenues was primarily due to the $35.4 million of trading losses as a result of the Facebook IPO. As a percentage of total revenue, excluding the effects of the Facebook IPO and the one-time $10.0 million investment gain from a strategic investment, Employee compensation and benefits decreased to 41.6% for the three months ended June 30, 2012 , from 43.0% for the comparable period in 2011. The number of full time employees increased to 1,535 at June 30, 2012 , from 1,465 at June 30, 2011 , primarily due to the acquisition of our futures business and the expansion of our market making and reverse mortgage businesses, offset by the reduction in force in connection with our restructuring in third quarter 2011. Employee compensation and benefits expense fluctuates, for the most part, based on changes in our business mix, revenues, profitability, and the number of employees. Execution and clearance fees decreased to $53.2 million for the three months ended June 30, 2012 , from $58.7 million for the comparable period in 2011. As a percentage of total revenue, Execution and clearance fees increased slightly to 18.4% for the three months ended June 30, 2012 , from 18.0% for the comparable period in 2011. Execution and clearance fees fluctuate based on changes in transaction volumes, shift in business mix, regulatory fees and operational efficiencies and scale. Payments for order flow decreased 9.8% to $20.2 million for the three months ended June 30, 2012 , from $22.3 million for the comparable period in 2011. As a percentage of total revenue, Payments for order flow increased slightly to 7.0% for the three months ended June 30, 2012 , from 6.9% for the comparable period in 2011. Payments for order flow fluctuate as a percentage of revenue due to changes in volume, reverse mortgage loan production, client and product mix, profitability, and competition. 53

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All other expenses increased by 5.8%, or $4.3 million , to $79.7 million for the three months ended June 30, 2012 from $75.3 million for the comparable period in 2011. Interest expense increased primarily due to our increased securities lending activity and long-term debt. Communications and data processing expense increased primarily due to higher market data and connectivity expenses as a result of our overall growth. Business development expense decreased due to fewer client related events. Occupancy and equipment rentals expense decreased primarily due to the reduction in lease costs. Professional fees decreased slightly due to lower consulting expenses. Other expenses decreased slightly due to lower reserves associated with our GNMA issuances, offset, by higher administrative expenses. Our effective tax rate from continuing operations of 38.6% and 39.7% for the three months ended June 30, 2012 and 2011, respectively, differed from the federal statutory rate of 35% primarily due to state and local income taxes and non-deductible charges.

Six Months Ended June 30, 2012 and 2011

Revenues Market Making For the six months ended June 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 45.4 $ 56.3 $ (10.9 ) -19.4 % Net trading revenue (millions) 219.0 251.3 (32.3 ) -12.9 % Interest, net (millions) 1.2 4.6 (3.4 ) N/M Total Revenues from Market Making (millions) $ 265.7 $ 312.2 $ (46.6 ) -14.9 % U.S. equity Market Making statistics: Average daily dollar value traded ($ billions)* 21.5 24.4 (2.9 ) -11.9 % Average daily trades (thousands)* 3,324.3 3,347.7 (23.3 ) -0.7 % Nasdaq and Listed shares traded (billions)* 93.0 104.9 (11.9 ) -11.3 % FINRA OTC Bulletin Board and Other shares traded (billions)* 338.1 582.6 (244.5 ) -42.0 % Average revenue capture per U.S. equity dollar value traded (bps)* 0.92 0.97 (0.05 ) -5.4 % Average revenue capture per U.S. equity dollar value traded, excluding impact of Facebook IPO (bps)** 1.01 0.97 0.04 4.1 %

* Represents new presentation for U.S. equity Market Making for all periods

presented as described more fully in text below.

** Statistic excludes $26.0 million in trading losses related to the Facebook

IPO.

Totals may not add due to rounding.

N/M - Not meaningful

Total revenues from the Market Making segment, which primarily comprises Net trading revenue from our domestic businesses, decreased 14.9% to $265.7 million for the six months ended June 30, 2012 , from $312.2 million for the comparable period in 2011. Revenues for the six months ended June 30, 2012 were negatively impacted by $26.0 million of trading losses related to the Facebook IPO 54

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and lower volumes, which resulted in a decrease in revenues from both our client and non-client quantitative trading models offset, in part, by slightly higher average revenue capture per U.S. equity dollar value traded, excluding the impact of Facebook IPO. Average revenue capture per U.S. equity dollar value traded was 0.92 basis points ("bps") for the first half of 2012, down 5.4% from the first half of 2011. Excluding the impact of the Facebook IPO, average revenue capture per U.S. equity dollar value traded was 1.01 bps for the first half of 2012, up 4.1% from the first half of 2011. Excluding the impact of the Facebook IPO, the primary driver for the increase in revenue capture was due in part to growth and enhancements to our trading models and infrastructure. Domestic U.S. Equity Market Making Revenues were $246.2 million , $272.2 excluding the impact of Facebook IPO, and $295.2 million for the six months ended June 30, 2012 and 2011, respectively.

Institutional Sales and Trading

For the six months ended June 30, 2012 2011 Change % of Change Commissions and fees (millions) $ 221.3 $ 239.4 $ (18.1 ) -7.6 % Net trading revenue (millions) 34.6 25.9 8.7 33.6 % Interest, net (millions) (4.3 ) (5.2 ) 1.0 18.8 % Investment income and other, net (millions) 0.3 2.2 (1.9 ) -86.1 % Total Revenues from Institutional Sales and Trading (millions) $ 251.9 $ 262.3 $ (10.3 ) -3.9 %

Totals may not add due to rounding.

Total revenues from the Institutional Sales and Trading segment, which primarily comprises Commissions and fees from institutional equities, ETFs, fixed income sales and reverse mortgage originations, decreased 3.9% to $251.9 million for the six months ended June 30, 2012 , from $262.3 million for the comparable period in 2011. Revenues were negatively impacted by $9.4 million of trading losses related to the Facebook IPO and lower revenues from our capital markets and equity sales businesses offset, in part, by higher revenues from our listed derivatives, fixed income, and reverse mortgage businesses.

Electronic Execution Services

For the six months ended June 30, 2012 2011 Change % of Change

Commissions and fees (millions) $ 87.7 $ 82.8 $ 4.9 6.0 % Investment income and other, net (millions) (0.2 ) (0.5 ) 0.3 N/M Total Revenues from Electronic Execution Services (millions) $ 87.5 $ 82.3 $ 5.2 6.4 % Average daily Knight Direct equity shares (millions) 217.3 163.7 53.6 32.7 % Average daily Knight Hotspot FX notional dollar value traded ($ billions)* 28.0 29.5 (1.5 ) -5.2 %

* In the second quarter of 2012, we modified the reporting of Knight Hotspot FX

notional dollar value traded volume to count one side of the transaction. We

previously counted total client volume to include both sides of the

transaction.

Totals may not add due to rounding.

N/M - Not meaningful 55

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Total revenues from the Electronic Execution Services segment, which primarily comprises Commissions and fees from agency execution activity, increased 6.4% to $87.5 million for the six months ended June 30, 2012 , from $82.3 million for the comparable period in 2011. Revenues were positively impacted by higher volumes from our Knight Direct and Knight BondPoint businesses. Corporate and Other For the six months ended June 30, 2012 2011 Change % of Change Total Revenues from Corporate and Other (millions) $ 33.2 $ 9.0 $ 24.2 269.3 % Total revenues from the Corporate and Other segment, which primarily represent interest income from our securities borrowing activity, gains or losses on strategic investments, and deferred compensation investments related to certain employees and directors, increased to $33.2 million for the six months ended June 30, 2012 , from $9.0 million for the comparable period in 2011. The primary drivers for the increase in revenues were a $10.0 million gain from a strategic investment that we account for under the equity method of accounting, offset, in part, by higher interest expense related to our long-term debt and securities lending activity. This investment gain was due to an income tax benefit recognized by the investee that arose from a change in its tax status during 2010, but which was reported and disclosed to us in the second quarter of 2012. The $10.0 million gain that we recorded in the second quarter of 2012 represents our share of the investee's net income which we recorded under the equity method of accounting. Expenses Employee compensation and benefits expense decreased to $278.1 million for the six months ended June 30, 2012 from $289.1 million for the comparable period in 2011. As a percentage of total revenue, Employee compensation and benefits increased slightly to 43.6% for the six months ended June 30, 2012 , from 43.4% for the comparable period in 2011. The decrease on a dollar basis was primarily due to an overall decrease and change in the mix of our revenues across businesses as well as by a decrease in guaranteed compensation from our Institutional Sales and Trading segment. As a percentage of total revenue, excluding the effects of the Facebook IPO and the one-time $10.0 million investment gain from a strategic investment, Employee compensation and benefits decreased to 41.9% for the six months ended June 30, 2012 , from 43.4% for the comparable period in 2011. Execution and clearance fees decreased to $106.4 million for the six months ended June 30, 2012 , from $112.2 million for the comparable period in 2011. As a percentage of total revenue, Execution and clearance fees decreased slightly to 16.7% for the six months ended June 30, 2012 , from 16.9% for the comparable period in 2011. Execution and clearance fees fluctuate based on changes in transaction volumes, shift in business mix, regulatory fees and operational efficiencies and scale. Payments for order flow decreased 2.8% to $41.8 million for the six months ended June 30, 2012 , from $43.0 million for the comparable period in 2011. As a percentage of total revenue, Payments for order flow increased slightly to 6.6% for the six months ended June 30, 2012 , from 6.5% for the comparable period in 2011. Payments for order flow fluctuate as a percentage of revenue due to changes in volume, reverse mortgage loan production, client and product mix, profitability, and competition. There was no writedown of assets and lease loss accrual for the six months ended June 30, 2012 . Writedown of assets and lease loss accrual of $0.9 million for the six months ended June 30, 2011 relate to excess real estate capacity. 56

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All other expenses increased by 8.2%, or $11.5 million , to $152.5 million for the six months ended June 30, 2012 from $141.0 million for the comparable period in 2011. Interest expense increased primarily due to our increased securities lending activity and long-term debt. Communications and data processing expense increased primarily due to higher market data and connectivity expenses as a result of our overall growth. Business development expense decreased due to fewer client related events. Occupancy and equipment rentals expense decreased primarily due to the reduction in lease costs. Professional fees decreased slightly due to lower consulting expenses. Other expenses decreased slightly due to lower reserves associated with our GNMA issuances, offset, by higher administrative expenses. Our effective tax rate from continuing operations of 38.7% and 39.2% for the six months ended June 30, 2012 and 2011, respectively, differed from the federal statutory rate of 35% primarily due to state and local income taxes and non-deductible charges.

Financial Condition, Liquidity and Capital Resources

Refer to the "Subsequent Event" section herein for a discussion of the impact on our liquidity and capital resources as a result of the event that occurred on August 1, 2012 . 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 June 30, 2012 and December 31, 2011 , we had $9.19 billion and $7.15 billion , respectively, in assets, a portion of which consisted of cash or assets readily convertible into cash as follows (in millions):

June 30, December 31, 2012 2011 Cash and cash equivalents $ 364.8 $ 467.6 Financial instruments owned, at fair value: Equities