SIFMA – Technology Management ConferenceNew York

June 19-21, 2007

Liquidity Management:Driving Advanced Execution Past Algorithms

Presented byLarry Tabb

Founder & CEOTABB Group

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Agenda

What is liquidity management?

Why do we need it?

How does it work?

Why bother?

What are the challenges?

Conclusions

3

Liquidity management

The math and technology around the appropriate handling of

Customer orders,

Liquidityprovisioning, and

The management of firm-wide risk and capital

4

Hunh?

A broker helps others manage riskBy selling risk exposure or mitigation

Brokers do this on an Agency basis

Getting products directly from others and marking them up, orPrinciple basis

Selling products out of inventory that has been pre-stocked

The pricing of this risk is determined by The MarketRisk exposure

Counterparty, Credit, Market, Liquidity, and operational Current, projected, and optimal

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Liquidity management is the management of order flow, capital, and risk

How do we manage customer agency order flow?What is our counterparty risk?

How do I provide risk exposure/mitigation to our client?Is there liquidity in the market?How do I get it?

Do we need to provide capital?How do we price it?

How does this impact the desk and the firm?What is the desk’s risk?

What do we want it to be?How do we get there?

What is the firm’s risk?What do we want it to be?How do we get there?

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Why do we need it?

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Finding liquidity in an electronic world can be frustrating

Traditionally, trading decisions were made by a trader

Today, more flow is electronic Equity order size has decreased to about 350 shares per trade

There are more market centers than ever that are “more accessible”

The tease factor is highBrokers are making their liquidity electronically accessible but…

Connecting is a challengeLiquidity is dark

Commissions are falling and firms are looking closely at cost

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Bundled/High touch order flow continues to decline as more flow directed to e*channels

47%

9%

14%

21%

9%

36%

10%

18%

24%

12%

Sales Desk

ProgramDesk

Direct ToExchange

Algorithms

CrossingNetwork

2006 2008

Shares by execution venue (share weighted)

-12%

5%

13%

7%

15%

2 Year CAGR

Source: TABB Group “Institutional Equity Trading 2006

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While exchanges talk of consolidation, fragmentation is a more appropriate discussion

713512784446610Total Investments

Merrill Lynch – 7

Interactive Brokers – 3

Boat

NSX

ISX

Phlx

BO

X

Fidelity – 2

Bank of America – 2

JP Morgan Chase – 4

Knight Capital – 3

Lehman Brothers – 4

BID

S

LeveL

Goldman Sachs – 4

Deutsche Bank – 4

UBS – 5

Van Der Moolen – 2

Citadel – 2

E*Trade – 2

Morgan Stanley – 6

Bear Stearns – 4

Citigroup – 9

Credit Suisse – 9

Turq

BA

TS

CB

SX

CSX

BSE

Firms With More Than 2 Investments in Alternative Venues

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Dark pools & crossing nets are fragmenting as at least 37+ are in or near production in US

Citigroup, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley,UBS, Credit Suisse,Bear, BofA, Deutsche, JPMorgan, Knight

BIDS

LeveL

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

Source: TABB Group, Companies, Fidelity Capital Markets

BlockHunterBloomberg

Posit Now Block Alert MerrillPosit MatchITG

NYFIX

Open IntradayEnd of Day CrossNasdaq

MatchPointNYSE

NaturalMillenniumH20LiquidnetLiquidnet

PipelinePipeline

Cross FinderCredit Suisse

Sigma XGoldmanTrajectory CrossingMorgan Stanley

PINUBSLiquifiCitiGroup

Citadel Ex SvsCitadel

MLXNMerrill

Intraday End of Day Continuous VWAP CrossInstinet

Opening CrossArca

LCXLehmanLiquidity PingATDKnight MatchKnight

LatticeState StreetCrossStreamFidelity

ConvergEx CrossConvergEx

AXP (Algo Cross)

MidPoint MatchISE

Pool

BlockCrossPulse

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Crossing Networks

The choice of liquidity pools is challenging at best

NYSENASDAQ

Exchanges

AMEXBSE

ChicagoNSXPHLX

LeveL

Nasdaq

H20

POSITNow

BlockAlert

Instinet

LavaATSMS Pool

Pipeline

SigmaXUBS PIN

ATDCitadel

Citi LiquifiCrossFinderKnightMatch

Lattice

POSITCross

BATS

DirectEdge

LavaFlow

TrackECN

TradeBook

ECNs

LiquidnetBIDS

Negotiation

Call Markets

Millennium

Continuous – Blind

MatchPoint

Broker - DarkPools

Transition Platforms

CBSX

DerivativeExchanges

ISE

NASDAQ

ARCA

BATS

Dark Orders

ARCA

HybridConvergEx

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With more venues and dark pools the trading process has become more complex

PortfolioManager Orders

Buy-SideTrader

Specific Broker

Buy-side onlyXing Network

Can I Add

Value?

To Market

No

YesNew Buy-Side Order Flow Process

Can I Find

Natural?Yes

Time/PriceAlgorithm

Buy / Sell-sideNegotiation

Networks

Dark Liquidity

NoYes

Dark Algo

Yes

Aggregation

Broker Capital

No

Out of Options

No

Small FootprintAlgos

Displayed liquidity Algos

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On the fixed income side no one even talks the same language - a host of models exist

Corporations

Inter-dealerBrokers

Brokers Brokers

Brokers

Brokers

Brokers

Brokers

Brokers

Brokers

Brokerage Accounts

Institutional Investors

Mutual funds& SMAs

Treasury & Corp Finance

Individual Investors

Retail Bond Distributon Platformseg. BondDesk & ValueBond

Bid/Offer Real-time marketsEg, Brokertec, EuroMTS & eSpeed

Institutional RFQ PlatformsEg. TradeWeb, MarketAxess, & Reuters

Single Dealer SystemEg, ML, GS, BARX…

Underwriting SystemsEg, Bloomberg & Ipreo

FIX for FI Protocol Eg. Lehman & Charles River

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How does this work

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Call Markets

Negotiation

First aspect – managing agency customer order flow – in most firms this is done

ExchangesExchangesExchangesExchangesExchanges

Dark Pools

Negotiation

Call Markets

ExchangesExchangesExchangesECNs

ExchangesExchangesExchangesExchangesContinuous

Broker

DMA

Algorithmic Flow

Algorithmic Flow

Feed HandlerFeed Handler

Event Stream Processor

Time SeriesDatabase

Order Generator

Order Staging

Order Router

Institution

Portfolio MgtSystem

Order MgtSystem

Execution MgtSystem

AgencyBlock

InternalDark Pool

Credit Risk

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Marginal DeskRisk

The next is managing capital, this is much harder

DeskPositions

DeskPositions

ConsolidatedPositions

Marginal DeskRisk

Marginal Enterprise

Risk

Position Needing Capital

Counter-partyRisk

MarketData

ValuationEngine

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All together you have a comprehensive way to manage order flow and capital

Pricing / Valuation

ProprietaryTrading

Internal MatchingEngine

DMA/Order Routing

Algorithms

MarketData

Customer Order Flow

Exchange

ECN

External Dark Pool /

Crossing Network

Capital

Liquidity Management

Automated MarketMaking

Capital Trades

AgencyBusiness

PrincipalBusiness

Sales Desk

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Why bother

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Industry is increasingly global & more complex as foreign markets have outperformed the US

India

Korea

Japan

DAX

CAC

FTSE

HK

S&P

China

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Traditional funds are beginning to push the envelope as they launch alternative products

54%

40%

35%

Large

Medium

Small

Institutional managers launching hedge funds (2006)

No83%

Yes17%

Institutional managers planning on launching hedge funds by ‘08

Source: TABB Group “Institutional Equity Trading In America 2006”

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Derivatives business expanding at record levels with no end in sight

308 317 380 449555

790 8881,002

1,207

1,514

2,537

1,917

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

US Derivatives Contracts Traded (in millions)

Source: Options Clearing Corporation, Futures Industry Association

11 Year CAGR21.1%

1 Year Growth Rates

20.5%25.4%

26.6%

32.3%

7yr CAGR 18.4%

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Quest for alpha is greater today than ever before

Greater competition for returns

Development of leveraged funds (120/20s)

More creative ways to manage exposures

Significant push to manage across asset classes

Hedge funds driving coverage teamsRisk and technology platforms need to follow suitCoverage teams need greater coordination and education

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Increased leverage of firm’s capital generate greater returns, but at increased risk levels

12%15% 14% 15%

8%

35% 35%

59% 60%66%

53% 50%

27% 25% 24%

Merrill Lynch LehmanBrothers

GoldmanSachs

Credit Suisse MorganStanley

Commissions Trading Profits Other

Major brokers’ ’06 revenue stream segmented by commissions and trading profits

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Commission pressure has forced firms to focus on electronic channels

% Decrease ’05 to ‘06

4.00

2.20

1.80

1.70

1.90

3.85

1.74

1.62

1.22

1.17

SalesDesk

ProgramDesk

CrossingNetwork

Direct toExchange

Algorithms

2005 2006

-4.0%

-21.0%

-10.0%

-28.0%

-38.0%

Average per share costs (pennies)

Source: TABB Group “Institutional Equity Trading 2006

¢¢

¢¢

¢¢

¢¢

¢¢

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What are the challenges and opportunities?

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Existing siloed infrastructure makes it challenging to manage risk in real-time

Brokerages have typically organized by productTrading, sales and supportOperations and reporting structures IT architecturesFront-end and client-facing technologies

However, things are changingManagement is becoming more cross product Products becoming more globalTrading becoming more horizontally integratedSales and support becoming more horizontal

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Data and enterprise risk management challenges make real-time analysis difficult

Data managementLack of clean and reliable data make valuation challenging

Especially in illiquid, complex, and challenging derivatives positionsThis is where clean data is most needed

Risk ManagementThe complexity of running enterprise risk valuations or complex portfolio valuations using Monte Carlo simulations is very calculation-dependentChallenging for even (especially) the largest firms to do this in real-time

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Liquidity management allows for more efficient use of capital

Agency flow will be more efficiently and effectively routed

The more automated the routing and execution the lower the costLeaving only the most difficult orders to be manually handled

Orders that need or would be advantaged by principal would be more effectively

Highlighted, priced, and managed

Risk on the desk, floor and business will be more effectively managed as limits, positions, and hedges could be more effectively managed, changed, and monitored

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Conclusions

Electronic trading has not hit its peakEquity side is mostly agencyThe OTC side is mostly principle

The challenge is marrying these two models

Liquidity Management will help firms strategicallyManage order flowAnalyze and transfer riskPrice capitalHedge positions

While firms are starting down this path, the road is long and will be met by data, organizational, and technology roadblocks

SIFMA – Technology Management ConferenceNew York

June 19-21, 2007

Liquidity Management:Driving Advanced Execution Past Algorithms

Presented byLarry Tabb

Founder & CEOTABB Group