| INVESTMENT TECHNOLOGY GROUP INC Item 1A Risk Factors Certain Factors That May Affect Our Results of Operations While our management’s long-term expectations are optimistic, we face risks or uncertainties that may affect our results of operations |
| The following conditions, among others, should be considered in evaluating our business and growth outlook |
| Financial Market Conditions and General Economic and Political Conditions The demand for our securities brokerage and related services is directly affected by factors such as economic and political conditions that may lead to decreased trading activity and prices in the securities markets generally |
| The future economic environment may be subject to periodic economic downturns, such as recessions, as well as geopolitical unrest, war and acts of terrorism in regions where we do business or otherwise, which could also result in reduced trading volumes and prices, which could materially harm our business, financial condition and operating results |
| Over the last year, the institutional equities market in the US has also experienced continued pricing pressure on commission revenues |
| Our business is materially affected by conditions in both domestic and foreign financial markets |
| We anticipate a continuation of the weak pricing environment in the immediate future |
| Decreases in Trading Volumes or Market Prices Declines in the volume of securities trading and in market liquidity generally result in lower revenues from our POSIT, Client Site Trading Products and Electronic Trading Desk products |
| In addition, our 15 ______________________________________________________________________ trading commissions outside the US and Canada are based on the value of transactions (rather than volume based), which would be adversely affected by price declines |
| Our profitability would be adversely affected by a decline in trading revenues because a significant portion of our costs are fixed |
| For these reasons, decreases in trading volume or securities prices could have a material adverse effect on our operating results |
| Regulation General The securities markets and the brokerage industry in which we operate are subject to extensive regulation in the United States and other jurisdictions around the world |
| We face the risk of significant intervention by regulatory authorities in all jurisdictions in which we conduct business |
| In our case, the impact of regulation extends beyond “traditional” areas of securities regulation, such as disclosure and prohibitions on fraud and manipulation by market participants, to the regulation of the structure of markets |
| The securities industry has been subject to several fundamental regulatory changes |
| In the future, the industry may become subject to new regulations or changes in the interpretation or enforcement of existing regulations, which may adversely affect our business |
| The markets for equity securities have been subject to the most significant regulatory changes |
| We cannot predict the extent to which any future regulatory changes can affect our business |
| On June 9, 2005 the SEC adopted “Regulation NMS” |
| Regulation NMS incorporates four substantive provisions related to the regulatory structure of the US equity markets |
| Subject to applicable exceptions, Rule 611 of Regulation NMS requires trading centers (which would include national securities exchanges, national securities associations that operate an SRO trading facility, ATSs (such as POSIT Match and POSIT Now), exchange market makers, broker-dealers that execute orders internally by trading as principal, or broker-dealers, such as ITG Inc, that execute orders internally by crossing orders as agent) to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers |
| To be protected, a quotation must be immediately and automatically accessible |
| Rule 610 requires fair and non-discriminatory access to quotations, establishes a limit on access fees, and requires each national securities exchange and national securities association to adopt and enforce rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations |
| Rule 612 generally prohibits market participants from accepting, ranking or displaying orders, quotations or indications of interest in pricing increments finer than one penny |
| The rule does not prohibit systems, such as POSIT, that match unpriced orders at the midpoint of the best bid and offer from executing such orders in share prices of less than one cent |
| Finally, Regulation NMS would amend the various national market system joint industry quotation and trade reporting plans to modify the formulas for allocating net income among the exchanges and national securities associations that are the participants of such plans |
| The effective date of Regulation NMS was August 29, 2005, however the implementation date for Rule 612 was extended until January 31, 2006, and for the other rules until June 29, 2006 |
| SEC staff have indicated publicly that it is highly likely that the June 29 implementation date will be delayed, perhaps for several months or longer to enable the SEC and the industry to address implementation issues |
| At this date, however, the SEC has not formally announced any delay in the implementation date |
| As a result, we cannot predict the extent to which any future regulatory changes associated with most of the rules in Regulation NMS would affect our business |
| As Rule 612 has been in place for a very short period of time, it is difficult to predict the long term effects of this rule on our business |
| Nevertheless, in the short term, implementation of Rule 612 has not adversely affected our business |
| 16 ______________________________________________________________________ Regulation ATS Before Regulation ATS went into effect on April 21, 1999, we operated POSIT pursuant to a “no-action” letter from the SEC staff which stated that it would not commence an enforcement action if POSIT were operated without registering as an exchange |
| We are currently operating POSIT and TriAct as part of our broker-dealer operations in accordance with Regulation ATS Accordingly, neither POSIT nor TriAct is registered with the SEC as an exchange |
| There can be no assurance that the SEC will not in the future seek to impose more stringent regulatory requirements on the operation of alternative trading systems such as POSIT and TriAct |
| There can be no assurance that Congress will not enact additional legislation applicable to alternative trading systems |
| In addition, certain of the securities exchanges have actively sought to have more stringent regulatory requirements imposed upon automated trade execution systems |
| Similarly, the non-US POSIT systems are subject to various regulations in the jurisdictions in which they operate, changes to which can have a negative impact on each POSIT system’s ability to operate |
| Net Capital Requirement Each of our broker-dealer subsidiaries is subject to regulatory capital requirements promulgated by the regulatory and exchange authorities of the countries in which they operate |
| The failure by any of these subsidiaries to maintain its required regulatory capital may lead to suspension or revocation of its broker-dealer registration and its suspension or expulsion by US or international regulatory bodies, and ultimately could require its liquidation |
| We do not currently maintain any credit facilities in the event of a regulatory capital shortfall |
| Historically, all regulatory capital needs of ITG Inc, AlterNet and ITG Execution Services have been provided by cash from operations |
| While we believe that cash flows from operations will continue to provide ITG Inc, AlterNet and ITG Execution Services with sufficient regulatory capital, we have established a dlra25 million credit facility which can be accessed to supplement our existing regulatory capital, as needed |
| Soft Dollars In the US, the provision of research to investment managers in consideration of commissions is conducted in conjunction with the investment manager’s reliance upon the safe harbor provided under Section 28(e) of the Securities Exchange Act of 1934 |
| The safe harbor protections of Section 28(e) apply equally to the provision of independent third-party research, as well as proprietary research |
| The SEC from time to time has been urged by competitors of the Company and others to seek Congressional reconsideration of Section 28(e) or alter its scope, including modifying the nature of Section 28(e) from a safe harbor to a mandatory regime for the use of soft dollars applicable to all investment advisors (including those not registered with the SEC) |
| In October 2005, the SEC published a proposed interpretation which, among other things, sought to narrow the scope of services which constitute “research” within Section 28(e) |
| While we do not believe that adoption of the proposed soft dollar interpretation will have a material adverse effect on our business, we can not predict whether the SEC will adopt a final interpretation in the form originally proposed, or whether the SEC will act to further restrict our clients ability to use soft dollars |
| Similarly, increased scrutiny placed upon soft dollar practices in light of the recent SEC attention to this area, may cause certain clients to further restrict their use of soft dollars, which could, in the aggregate, materially impact our business |
| From time to time, other regulatory or governmental entities, as well as industry groups, have issued statements, reports and best practices regarding soft dollars |
| Any regulatory changes or industry best practices that narrow the definition of research provided in Section 28(e) or limit the scope, or modify the nature, of the Section 28(e) safe harbor, or impose onerous record-keeping, reporting or other obligations regarding soft dollar and directed brokerage arrangements could have a material adverse effect on our operations |
| 17 ______________________________________________________________________ Competition The financial services industry generally, and the securities brokerage business in which we engage in particular, is extremely competitive, and we expect it to remain so |
| The automated trade execution and analysis services offered by us compete with services provided by leading brokerage firms and transaction processing firms and with providers of electronic trading and trade order management systems and financial information services |
| POSIT also competes with various national and regional securities exchanges and execution facilities, the Nasdaq National Market, ATSs and ECNs for trade execution services |
| In addition, the number of trading products that compete with our Client Site Trading Products has been increasing |
| Many of our competitors have substantially greater financial, technical, marketing and other resources which, among other things, enable them to compete with the services we provide on the basis of price, and a willingness to commit their firms’ capital to service a client’s trading needs on a principal, rather than on an agency, basis |
| Many of them offer a wider range of services, have broader name recognition and have larger customer bases than we do |
| Outside the United States, in addition to our US competitors with international capabilities, we compete with non-US financial service companies that may also have long-standing, well-established relations with their clients, some of which also hold dominant positions in their trading markets |
| We believe that our services compete on the basis of access to liquidity, transaction cost and market impact cost reduction, timeliness of execution and probability of trade completion |
| Although we believe that POSIT, Triton, Radical, ITG Algorithms, the Electronic Trading Desk and our Analytical Products and Research services have established certain competitive advantages, our ability to maintain these advantages will require continued identification of enhancements to our products, investment in the development of our services, additional marketing activities and customer support services |
| There can be no assurance that we will have sufficient resources to continue to make this investment, that our competitors will not devote significantly more resources to competing services or that we will otherwise be successful in maintaining our current competitive advantages |
| Insufficient System Capacity or System Failures Our business relies heavily on the computer and communications systems supporting our operations |
| Peak trading times and times of unusual market volatility could cause our systems to operate slowly or even fail for periods of time, as could general power or telecommunications failures or natural disasters, despite the contingency plans we have in place |
| Moreover, we have varying levels of contingency plan coverage among our non-US subsidiaries |
| The presence of computer viruses can also cause failure of our systems |
| As our business expands, we will need to expand our systems to accommodate an increasing volume of transactions |
| If any of our systems do not operate properly or are disabled, we could incur financial loss, liability to clients, regulatory intervention or reputational damage |
| System failure or degradation could lead our customers to file formal complaints with industry regulatory organizations, initiate regulatory inquiries or proceedings, file lawsuits against us, trade less frequently through us or cease doing business with us |
| Rapid Changes in Technology Due to the high demand for technology-based services in the securities industry, we are subject to rapid technological change and evolving industry standards |
| Also, customer demands become greater and more sophisticated as the dissemination of information to customers increases |
| If we are unable to anticipate and respond to the demand for new services, products and technologies in a timely and cost-effective manner and to adapt to the technological advancements and changing standards, we will be less able to compete effectively, which could have a material adverse effect on our business |
| Similarly, the development of technology-based services is a complex and time-consuming process |
| New products and enhancements to existing products can require long development and testing periods |
| Significant delays in 18 ______________________________________________________________________ new product releases or significant problems in creating new products could negatively impact our revenues |
| Credit Risk We are exposed to credit risk from third parties that owe us money, securities, or other obligations, including our customers and trading counterparties |
| These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons |
| Substantially all of the clearing and depository operations for our broker-dealer subsidiaries are performed pursuant to clearing agreements with their clearing brokers, who review the credit risk of trading counterparties, as deemed necessary |
| Volatile securities markets, credit markets and regulatory changes increase our exposure to credit risk, which could adversely affect our financial condition and operating results |
| Infrastructure and Research In connection with our research and product development activities, as well as capital expenditures to improve other aspects of our business, we incur substantial expenses that do not vary directly, at least in the short term, with fluctuations in securities transaction volumes and revenues |
| In the event of a material reduction in revenues, we may not be able to reduce such expenses quickly and, as a result, we could experience reduced profitability or losses |
| Conversely, sudden surges in transaction volumes can result in increased profit and profit margin |
| To ensure that we have the capacity to process projected increases in transaction volumes, we have historically made substantial capital and operating expenditures in advance of such projected increases, including during periods of low transaction volumes |
| In the event that such growth in transaction volumes does not occur or we are not able to bring a research or product idea to fruition (or do not accurately forecast the demand for any such product), the expenses related to such investments could cause reduced profitability or losses |
| Dependence on Major Customers Customers may discontinue use of our services at any time |
| The loss of any significant customers could have a material adverse effect on our results of operations |
| In addition, the loss of significant POSIT customers could result in lower share volumes of securities submitted to POSIT systems around the world, which may adversely affect the liquidity of the systems, reducing their attractiveness to our customers and adversely affecting our trading volumes, operating results and financial condition |
| The chart below sets forth our dependence on our three largest clients individually, as well as on our ten largest clients in the aggregate, expressed as a percentage of total revenues: % of Total Consolidated Revenue 2005 2004 2003 Largest customer 6dtta6 % 6dtta1 % 5dtta4 % Second largest customer 2dtta7 % 2dtta2 % 4dtta0 % Third largest customer 2dtta6 % 2dtta2 % 3dtta1 % Ten largest customers 25dtta2 % 22dtta5 % 28dtta2 % Employee Misconduct or Errors Employee misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation |
| It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases |
| Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of customers or improper use of confidential information |
| 19 ______________________________________________________________________ Similarly, employee errors in recording or executing transactions for customers can cause us to enter into transactions that customers may disavow and refuse to settle |
| These transactions expose us to risk of loss, which can be material, until we detect the errors in question and unwind or reverse the transactions |
| As with any unsettled transaction, adverse movements in the prices of the securities involved in these transactions before we unwind or reverse them can increase this risk |
| Dependence on Third Party Suppliers for Key Services We depend on a number of third parties to supply elements of our trading systems, computers, communication infrastructure and other equipment, and related support and maintenance |
| We cannot be certain that any of these providers will be able to continue to provide these services in an efficient and cost-effective manner or that they will be able to meet our expanding needs |
| If we are unable to make alternative arrangements for the supply of these services in the event of a disruption in the services, our business, financial condition and operating results could be materially harmed |
| Dependence on Proprietary Intellectual Property; Risks of Infringement Our success is dependent, in part, upon our proprietary intellectual property |
| We generally rely upon patents, copyrights, trademarks and trade secrets to establish and protect our rights in our proprietary technology, methods and products |
| A third party may still try to challenge, invalidate or circumvent the protective mechanisms that we select |
| We cannot assure that any of the rights granted under any patent, copyright or trademark that we may obtain will protect our competitive advantages |
| In addition, the laws of some foreign countries may not protect our proprietary rights to the same extent as the laws of the US In the past several years, there has been a proliferation of so-called “business method patents” applicable to the computer and financial services industries |
| There has also been a substantial increase in the number of such patent applications filed |
| Under current law, US patent applications remain secret for 18 months and may, depending upon where else such applications are filed, remain secret until issuance of a patent |
| In light of these factors, it is not economically practicable to determine in advance whether our products or services may infringe the present or future patent rights of others |
| We believe that factors such as technological and creative skills of our personnel, new product developments, frequent product enhancements, name recognition and reliable product maintenance are essential to establishing and maintaining a state-of-the-art technological system |
| There can be no assurance that we will be able to protect our technology from disclosure or that others will not develop technologies that are similar or superior to our technology |
| It is likely that from time to time, we will receive notices from others of claims or potential claims of intellectual property infringement or we may be called upon to defend a joint venture partner, customer, vendee or licensee against such third party claims |
| Responding to these kinds of claims, regardless of merit, could consume valuable time, result in costly litigation or cause delays, all of which could have a material adverse effect on us |
| Responding to these claims could also require us to enter into royalty or licensing agreements with the third parties claiming infringement |
| Such royalty or licensing agreements, if available, may not be available on terms acceptable to us |