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Executives

Marge Wyrwas – Senior Managing Director of Communications, Marketing, and Investor Relations

Tom Joyce – Chairman and CEO

Steve Bisgay – Senior Managing Director and CFO

Jim Smyth – Executive Vice President

Greg Voetsch – Executive Vice President

Analysts

Betsy Miller – Goldman Sachs

Rich Repetto – Sandler O'Neill

Ken Worthington – JP Morgan

Mike Vinciquerra – BMO Capital Markets

Roger Freeman – Barclays Capital

Knight Capital Group (NITE) Q4 2008 Earnings Call January 22, 2009 9:00 AM ET

Operator

Good day and welcome to the Knight's Capital Group fourth quarter 2008 conference call. (Operator instructions). And now to kick off our program I'd like to turn the call over to Marge Wyrwas, Senior Managing Director of Communications, Marketing, and Investor Relations. Please go ahead.

Marge Wyrwas

Thank you Reika. Good morning ladies and gentlemen, I'm Marge Wyrwas. At this point you should have received copies of this morning's press release. If you didn't receive a copy or if you would like to have your name added to our company's email and fax list please contact a member of the CMIR team.

I am pleased to welcome you to Knight's fourth quarter 2008 conference call and Webcast. With me in the room today are Tom Joyce, Chairman and CEO, Steve Bisgay, Senior Managing Director and CFO who will make formal remarks.

Jim Smyth, Executive Vice President and Greg Voetsch, Executive Vice President are also in the room. Before we begin I'll briefly direct your attention to the cautionary terms regarding forward looking statements in today's discussion.

Certain statements contained herein and the documents incorporated by reference may constitute forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Please take a moment to read the Safe Harbor Statement contained in today's press release which is incorporated herein by reference.

In addition participants should carefully review the risks and uncertainties disclosed in the company's report with the U.S. Securities and Exchange Commission including, without limitations, those details under the heading certain factors affecting results of operation and risk factors, as well as, the company's consolidated financial statements and the notes thereto contained in the company's annual report on form 10-K for the ended December 31, 2007.

And quarterly report on form 10-Q for the three months ended September 30, 2008 and the recent documents the company filed with (inaudible) of the SEC from time to time. And now I'd like to turn the call over to Knight's Chairman and CEO Tom Joyce. TJ?

Tom Joyce

Thanks, Marge, and good morning everyone. Truly a remarkable quarter, historic in its impact, in the final three months of 2008 the global capital markets felt the full force of the aftershocks from the dramatic events in September, including the Lehman bankruptcy, the AIG bailout, and the sudden mass retreat in the U.S. Treasuries.

During the fourth quarter broad stock markets volumes surged on its sustained selling activity. The VIX averaged just over 58 with several intraday highs over 80 in the latter half of October. And for the quarter the Dow Jones Industrial average, the S&P 500, and the NASDAQ composite fell 19%, 22%, and 25% respectively.

As a firm in that challenging environment Knight achieved outstanding overall results. And, again, that environment did not lack for opportunities and challenges. So I'd like to take a moment to thank all of our employees for staying focused on our clients during a truly remarkable year in global capital markets where we witnessed a sweeping transformation on Wall Street which will studied and debated for decades.

Through a lot of hard work Knight is fast becoming an increasingly relevant and prominent part of the new Wall Street. During the fourth quarter of 2008 our Global Market segment turned in an exceptional performance. The U.S. equity trade volumes we recorded during the quarter are an indicator of just how far we've come over the past few years.

The results also reflect dramatically increased efficiencies through investments in our trade technology infrastructure, electronic trade offerings, and productivity to clients and external market centers. In addition we saw healthy contributions from commissions and fee like sources plus our high-velocity algorithmic trading models.

In our asset management segment it was a somewhat different story. The unprecedented market conditions and broad based de-leveraging among alternative investment managers factored into the continued poor performance of the Deephaven funds. Deephaven continues to consider all alternatives with the goal of protecting the interest of its investors.

Now a brief summary of our financial results, in the fourth quarter of 2008 Knight recorded total earnings of $0.89 per diluted share or $0.56 per diluted share from operations which excludes the effect of the partial sale of Knight's investment in Direct Edge.

Global Markets contributed pre-tax income of $125.8 million. Asset management recorded a pre-tax loss of $5.7 million and the corporate segment added pre-tax income of $21 million. Corporate benefited from the partial stake of Knight's ownership stake in Direct Edge Holdings to International Securities Exchange Holdings which is, of course, the ISE.

Total revenues for the fourth quarter 2008 were $330 million compared to $257 million for the fourth quarter of '07. Pre-tax income for the fourth quarter of '08 was $141 million significantly higher than the $78.9 million for the fourth quarter of 2007.

In consolidated pre-tax margins for the fourth quarter of 2008 were 30% and that is excluding the gain from the Direct Edge transaction. So let's turn to Global Markets. During the fourth quarter of 2008 we achieved exceptional performance on the strength of our deep in-house liquidity, hybrid market model, and the increasing diversity of our offerings, clients, and order flow.

Revenues for the fourth quarter 2008 increased 43% over the fourth quarter of 2007 while pre-tax income was up 58%. Looking at our U.S. equity trade volumes during the fourth quarter of 2008 order from buy and sell-side clients increased thanks to our client focus and in part due to the disruption on Wall Street.

The competitive landscape is changing. We believe the combination of our deep in-house liquidity and hybrid market model provides us with a compelling advantage in capturing a greater percentage of order flow. And while the environment has been tough for our clients and we've seen some turnover in our client base Knight still added clients, increased order flow from existing clients.

During the fourth quarter we had average daily trade volume of 4 million, average daily share volume of 3.8 billion, and average daily dollar value traded of 22.5 billion. The totals represent increases of 139%, 11%, and 30% respectfully when compared to the fourth quarter of 2007.

To put this in perspective, Knight had greater share volume during the fourth quarter than any U.S. exchange. The 242 billion shares we traded during the quarter was 24% higher than the top ranked exchange.

And in comparison to other securities firms, Knight ranked number one across the board in shares traded of U.S. Equities during the fourth quarter. According to the RTEX rankings we ranked number one in shares traded of listed, NASDAQ, and Bulletin Board Securities in October and November and December.

We are without question the leading source of off exchange liquidity in U.S. Equities. Due to our heritage, we've long been at or near the top in NASDAQ and Bulletin Board volumes. The dramatic growth of listed volumes, however, demonstrate the progress we've made in becoming an all-market trade execution firm.

Looking at our recent full year RTEX's rankings for listed securities in 2006, we ranked number 11 with just under 4%, in 2007 we moved up to number seven with 5.5% market share, and then for all of 2008 we finished at number two with almost 11% market share. The primary factors behind this growth include the expansion of our buy-side client base, the emergence of Knight Link, and additional listed order flow from existing clients.

Looking at our individual offerings, there are several highlights from the fourth quarter. Revenues from sell-side clients increased nicely due to increased order flow, due to our superb best execution statistics, the further expansion of Knight Link and our high-velocity algorithmic trading models. The electronic market making experienced growth as a result of a lot of hard work put towards deepening sell-side client relationships and generating more order flow. And we also benefitted to a certain extent from the disruption on Wall Street.

During the fourth quarter, Knight ascended to the number one position by share volume in TAB Groups liquidity matrix. Knight Link is an electronic access point into Knight's off exchange liquidity that we developed in-house and began actively marketing to new clients in mid 2007. Knight Link's average daily share volume during the fourth quarter of 2008 increased 157% over the fourth quarter of 2007.

Our high-velocity algorithmic trading models made a significant contribution to revenues and helped drive pre-tax margins in Global Markets during the fourth quarter. The models analyze and interact with street flow and look for price dislocations in individual U.S. Securities. Our quantitative strategists and programmers continually develop and refine our sophisticated proprietary models.

Revenues from buy-side clients also exhibited growth with strong contributions from both traditional institutional sales in trading and electronic trading services. Clients kept our sales raters busy as volatility spiked in October. The major markets began a swift, steep decline and buy-side firms were all scrambling to readjust portfolios.

The jump in activity, and it mirrored an industry wide trend, according to recent TAB Group report after years of incremental decreases order flow to sales traders increased, increased 19% from 2007 to 2008. The change in behavior due to market conditions is a further validation of Knight's Hybrid market model.

During the fourth quarter, of course, there was an additional dynamic. We were fighting for market share made available by the disruption among Wall Street firms. So not only were there more commissioned dollars going to sales traders but a higher percentage of those commissioned dollars were in play.

Among our institutional electronic trade execution services, Knight Direct and our suite of agency-only algorithmic trading strategies increased both clients and volume. Knight Direct introduced several new enhancements including complex options capabilities to aide multi-asset class trading. The platform has also been adapted to better suit European users. Our algos continue to provide excellent execution for our clients struggling to navigate these fragmented markets.

Initiatives to build liquidity across asset classes also evidenced solid growth during the fourth quarter. Knight Libertas, our institutional fixed income broker dealer, has recorded strong financial performance. Our newest acquisition grew volumes of bonds traded in credit, asset-backed, and mortgage-backed securities.

Knight Libertas continues to add to sales and trading teams in the areas of high-grade, high-yield ABS and MBS, as well as, to build up the credit research team. In the coming year Knight Libertas will focus on building and enhancing capabilities in convertibles, emerging markets, bank loan trading, and Capital Markets, as well as, adding to our fixed income team in London.

Knight Bond Point, our electronic retail-oriented fixed income trading platform, turned in a terrific fourth quarter of 2008. Trading volumes almost tripled over the same time period of 2007. During the full year of 2008, Knight Bond Point added more than 60 new clients as a result of cross selling to our broker-dealer client base. In addition full year revenues grew more than 45% from '07 to '08.

And finally during the fourth quarter we made further progress on the international front. In Europe we witnessed continued strong contributions from the sales and trading team there as they continued to grow market share.

Also we relocated Knight's London operation into a larger space with state of the art facilities. Importantly we are expanding off of our strong base there to enhance our offerings to European firms with additional trade execution services on the electronic side such as Knight Link, Knight Direct, and Knight Suite of agency-only algorithmic trading strategies.

In Asia, we are opening a new local office in Hong Kong on February 2nd that will be home to a dedicated institutional sales and trading team. And during the fourth quarter we hired a Head of Institutional Asian Equities and received approval as a participant on the Hong Kong Stock Exchange.

Turning now to asset management, the unprecedented market conditions continue to impact Deephaven's Fund performance amid industry-wide deleveraging and steep declines in the major market indexes.

Deephaven's fourth quarter performance was dramatically worse than the third quarter's due to the effects of the market environment including investors reduction in exposure to riskier assets, increases in margin and financing requirements by prime brokers, forced liquidations by hedge funds, insurance company, investment banks and others.

Deephaven's blended fund performance was negative 20.9% for the fourth quarter and negative 28.9% for all of 2008. That would exclude the performance of the Event Fund.

Since the Global Multi-Strategy Fund's return is about 75% of the blended return, a comparable index would be the HFRI relative value multi-strategy index which was down 20% for 2008. Deephaven had asset management fees of $7.5 million and recorded a pre-tax loss of $5.7 million in the fourth quarter of 2008. In comparison Deephaven had asset management fees of $28 million and a pre-tax loss of $426,000 in the fourth quarter of '07.

On October 30th of 2008 Deephaven announced the suspension of redemptions and withdrawals in the Global Multi-Strategy Fund and International Volatility Strategies Fund. This decision was prompted by the unprecedented market conditions, pending redemptions and industry wide changes in margin and finance requirements.

Deephaven continues to consider all alternatives with the goal of protecting the interests of its investors. As of January 1, 2009, assets under management were approximately $2 billion in comparison with assets under management as of January 1st of 2008 of around $4 billion.

As for the corporate segment, pre-tax income for the fourth quarter of 2008 was $21.1 million compared to a pre-tax loss of $40,000 in the fourth quarter of '07. Corporate revenues were driven by the partial sale of Knight's ownership stake in Direct Edge Holdings plus our remaining ownership stake in the ISE Stock Exchange to the ISE.

Following the closing of the transaction of December 23rd, we realized a pre-tax gain of $51.6 million. In all not a bad outcome for our October 2005 purchase of the attain ECN. Add to that Direct Edges is now established as a major market center. And we still hold a 19.9% ownership stake in Direct Edge Holdings.

Corporate revenues in the fourth quarter of '08 were offset by a pre-tax loss of $14.8 million from corporate investments in the Deephaven Funds. As of December 31st, Knight had $47.2 million in the Deephaven Funds.

Now I would like to turn the call over to Steve Bisgay for a more detailed financial review of the fourth quarter. I'll return later with some closing remarks and then we'll open it up for questions, Steve.

Steve Bisgay

Thank you, TJ, good morning. Before I review the business segment results I would like to briefly recap our overall fourth quarter performance. Our earnings were $79.7 million or $0.89 per diluted share. Pre-tax earnings including minority interest expense of $1.9 million related to Deephaven were $141.1 million. The quarterly results included a $51.6 million pre-tax gain from the partial sale of Direct Edge. Excluding this gain quarterly pre-tax results from operations were approximately $89.5 million or $0.56 per diluted share.

The main components of our fourth quarter pre-tax results are $125.8 million of earnings from global markets, a loss of $5.7 million from asset management, and earnings of $21.1 million from our corporate segment which includes the Direct Edge gain.

Let's review the results of our business segments starting with Global Markets. Global markets revenues we're $316.9 million during the fourth quarter, up 18% from the third quarter and up 43% from the fourth quarter of 2007. Global markets had pre-tax earnings of $125.8 million during the fourth quarter. This compares to pre-tax earnings of $88.3 million which we achieved in the third quarter of 2008 and $79.4 million in last year's fourth quarter.

Global market's strong performance was driven by a combination of factors including heightened intraday volatility and deleveraging in the markets, the continuing expansion of our client and product mix, increased contribution from high-velocity algorithmic trading models, and the scalability and efficiency of our hybrid market model.

Knight's U.S. equity dollar volume traded in the fourth quarter was $1.4 trillion or $22.5 billion per day which was up 13% from the third quarter and up 30% from last year's fourth quarter. Meanwhile we saw the VIX span from approximately 38 to 89.5 with a quarterly average of approximately 59 compared to 25 in the third quarter.

The success that the global market segment has experienced this quarter is directly attributable to our ability to adapt to changing market dynamics. Our hybrid market model which includes both electronic and voice products and services combines the benefits of high level client service and innovation that has helped redefine our product mix.

Our electronic products and services consist of our electronic trading group which includes Knight Link and our high-velocity algorithmic execution and trading products. As well as our other offerings such as, Knight Direct, Knight Match, Hotspot, and Knight BondPoint.

In the aggregate our electronic activities accounted for revenues of approximately $168 million or 53% of our fourth quarter global markets revenues compared to $135 million or 50% for the third quarter and 39% for all of 2007. Pre-tax margins for these products were close to 50% for the quarter and the year as compared to approximately 35% for 2007. These results include the growth and development of high-velocity algorithmic trading models which interact with street flow and have increasingly contributed to electronic products results.

We also had another solid contribution from our voice products and services which include our cash traders, U.S. and European institutional sales and the recently acquired Knight Libertas. In the aggregate our voice services contributed 47% of total global markets revenues with a corresponding pre-tax margin of 26%. Pre-tax margins for the year remain strong at approximately 23% which was consistent with 2007.

Our past acquisitions covering both our electronic and voice channels and multiple asset classes have also been a meaningful contributor to fourth quarter global markets results. During the quarter these acquisitions generated combined revenues of $66 million which represents approximately 21% of global markets revenues for the period.

On a GAAP basis they had a combined pre-tax margin of 16% which compares to an average margin of 12% over the prior three quarters. When you exclude non-cash related deal costs these businesses had a combined pre-tax margin of 21% in the fourth quarter.

The global market segment continues to benefit from our scalable platform. Pre-tax margins for global markets expanded to 40% during the fourth quarter up from 33% in the third quarter. This marks our fifth consecutive quarter in which global markets pre-tax margins exceeded 30%.

This trend is primarily result of the growth and success of our electronic products and services. In addition, our strong pre-tax margins reflect the expansion of our scalable platform and the benefits of operating leverage.

We continue to make investments in our business infrastructure. In the fourth quarter we invested approximately $8 million or approximately $0.05 per diluted share and a total of $13 million or $0.08 per diluted share in the second half of the year in our international expansion efforts and in the development of new products.

Now let's review the results of our asset management segment. Deephaven battled through a challenging fourth quarter to post a negative blended return of 21% across all assets under management. As a point of reference, Deephaven had a negative blend return of 10% during the third quarter and a positive blended return of 1.4% during the fourth quarter of 2007.

On a year-to-date basis Deephaven had a negative blended return of 32.6% or negative 28.9% excluding the performance of the Event Fund which does not generate fees as it is in the process of closing. Deephaven recorded asset management fees of $7.5 million during the fourth quarter down from $9.2 million in the third quarter and $28.2 million in last year's fourth quarter.

Management fees which are determined based on a percentage of assets under management were $6.4 million during the fourth quarter down from $8.6 million in the third quarter and down from $11.8 million in last year's fourth quarter.

Average assets under management during the fourth quarter of 2008 were $2.1 billion down from $2.9 billion in the third quarter and down from $4.2 billion in last year's fourth quarter. The decrease in assets under management was principally affected by performance of the funds. As of January 1, 2009 Deephaven's total assets under management were approximately $2 billion.

Incentive fees which vary based on the funds returned were $1.1 million in the fourth quarter up from $700,000 in the third quarter and down from $16.4 million in last year's fourth quarter. As announced on October 30th, Deephaven suspended redemptions in both the Global Multi-Strategy Fund and the International Volatility Strategist Fund. During the period of suspension these funds will continue to generate management fees and incentive fees to the extent that the performance exceeds their high water marks.

Please also note that revenues from the asset management segment include a $6.7 million loss related to employee deferred compensation plan assets which is fully offset by a decreased decompensation for the segment.

In the fourth quarter of 2008 asset management had a pre-tax loss of $5.7 million which included minority interest expense of $1.9 million. This compares to a pre-tax loss of $7.7 million in the third quarter which include a minority interest expense of $1.7 million and a pre-tax loss of $426,000 in the fourth quarter of 2007.

As previously announced in February 2008 the Deephaven managers exercised an option to acquire a 49% interest in Deephaven in exchange for the termination of their employment agreements. Following the exercise of the option pre-tax earnings our allocated between Knight and the Deephaven managers in a similar manner as under the previous employment agreements which included minimum annual distributions for the first fiscal year after exercise.

The fourth quarter's minority interest expense of $1.9 million represents the fourth quarter's accrual of the one year minimum distribution to the Deephaven managers recorded pursuant to the Deephaven Holdings LLC agreement. As previously disclosed the exercise of the option only affected the financial reporting of the profit sharing page of the Deephaven managers.

The amount accrued pursuant to the LLC agreement post exercise of the option is reported as minority interest expense instead of employee compensation and benefits as it is considered distributions to equity owners. As an additional reminder, we report the net returns from Deephaven Corporate Investments, with our other strategic investments within our corporate segment and not in the result of our asset management business segment.

Now, let’s discuss our corporate segment which includes the returns from our strategic investments and our corporate overhead expenses. For the fourth quarter, our corporate segment had pre-tax earnings of $21.1 million compared to a loss of $18.8 million in the third quarter and break-even results in last year’s fourth quarter.

The largest drive in results in the quarter related to the partial sale of our investment in Direct Edge which resulted in a pre-tax gain of $51.6 million. As a result of the structure of the transaction, $35.7 million of the total gain is included in investment income and other net, and $15.9 million is reported as non-operating gain from subsidiary stock issuance. In conforming with SEC rules the $15.9 million gain is reported in a separate section entitled “Other Income” below revenues and expenses.

The P&L impact of our corporate investment in the Deephaven Funds was a pre-tax loss of $14.8 million compared to a pre-tax loss of $8.5 million in the third quarter and a pre-tax gain of $4.9 million in the fourth quarter of 2007.

The average balance of our corporate investment in the Deephaven Funds was $50 million during the fourth quarter, down from $69 million in the third quarter and down from $194 million in the fourth quarter of 2007.

As you may recall, we redeemed $120 million in the fourth quarter of 2007.

Our blended return on our corporate investments, in the Deephaven Funds, was a loss of 23.3% compared to a negative blended return of approximately 11.7% during the third quarter and a positive return of 2.4% during last year’s fourth quarter.

Due to the mix of the Deephaven Funds, in which Knight has invested, the fourth quarter 23.3% loss on our corporate investment in the Deephaven Funds was greater than the negative 21% overall blended return of all of the assets under management at Deephaven.

Remember that a significant percentage of Knight's corporate investment is in Deephaven’s Global Multi Strategy Fund, which represents approximately 60% of Deephaven’s overall assets under management.

Now, let’s discuss our overall expense trends on a consolidated basis. Consolidated pre-tax margins were 43% in the fourth quarter, excluding the gain from the partial sale of Direct Edge. Consolidated pre-tax margins were 30.4% up from the third quarter’s consolidated pre-tax margins of 23%.

The increase in pre-tax margins excluding the Direct Edge sale is primarily due to the strong results in operating leverage within our Global Market segment, offset by the performance of our asset management segment and return on the corporate investment in the Deephaven Funds.

In the fourth quarter, compensation expense represented 33% of revenues when you exclude the revenues from the Direct Edge gain, down from 39% in the third quarter. Knights’ total head count was 1,045 at the end of the fourth quarter compared to 868 at December 31, 2007. The increase is due to the acquisitions of Edge Straight in the first quarter and Libertas in the third quarter, as well as, expansion and new product initiatives.

Given that asset management and corporate revenues have no corresponding transaction related expenses, we analyzed these expenses on an individual basis as a percentage of total net trading revenues plus commissions.

Execution and clearance represented approximately 10% of fourth quarter net trading revenues and commissions which is consistent with the third quarter and lower than the 11% in last year’s fourth quarter. These costs fluctuate as a percentage of revenue due to changes in volume, product mix and operational efficiencies and scale.

Softel expense represented 5% of net trading revenues and commissions in the fourth quarter of 2008, as compared to 7% in the third quarter and 8% in last year’s fourth quarter. Payment for order flow represented 5% of net trading revenues and commissions for the fourth quarter up slightly from 4% in the third quarter and consistent with 5% in last year’s fourth quarter. These costs fluctuate as a percentage of revenue due to changes in volume and profitability. All other expenses were $41.2 million in the fourth quarter, consistent with the $41.1 million in the third quarter.

Now let’s discuss our balance sheet. Our financial condition remains solid and liquid. As of December 31, we had $2 billion in assets, 62% of which consisted of cash or assets readily convertible into cash, principally security zoned and receivables from brokers and dealers. Additionally, we have approximately $47 million invested in the Deephaven Funds. We have $441 million in cash, and over $250 million in excess capital.

We employ limited leverage as evidenced by our 0.14 debt-to-equity ratio, resulting from our $140 million credit facility which we drew down within the last 15 months. We repurchased 301,000 shares, $4.6 million during the fourth quarter. Since the inception of the repurchase program in 2002, we have repurchased 67 million shares for $750 million. We had shareholders equity of $1 billion as of December 31, 2008.

Using our average diluted shares outstanding for the fourth quarter, 89.1 million, our book value is approximately $11.53 per diluted share. Finally, we have an unleveraged return on equity of 19% for 2008 or 16% when you exclude the sale of Direct Edge. This compares to a 13% unlevered ROE in 2007. Thank you for participating in our conference call today. Now I would like to turn the call back over to TJ.

Tom Joyce

Thanks Steve. In the fourth quarter of 2008, we achieved outstanding results in a period of considerable (inaudible). Knight is fast becoming an increasingly relevant and prominent part of the new Wall Street. Year-on-year improvement in financial performance reflects a successful and ongoing execution of our growth strategy in global markets.

We have steadily gained market share by focusing on and diversifying the client base, adding electronic market access and trade execution services within our Hybrid model, building up and balancing out our order flow across large, mid, small and micro caps, investing in sophisticated trade technology info structure, developing access and trading capabilities in new asset classes and exporting our approach to trading to new geographies.

Today, we are the leading source of off-exchange liquidity in U.S. equities across all sections of the market. Revenue contributions from commissions and fee like sources are increasing most notability from Knight Libertas. Revenues from our high-velocity algorithmic trading models are rising as well. We continued to increase margins, as well as, expand and diversify revenue. We are in the process of expanding our offerings to clients in Europe, and establishing a presence in Asia.

In asset management the unprecedented market conditions continue to impact Deephaven’s Fund performance. Deephaven continues to consider all alternatives with the goal of protecting the interest of its investors.

Our future performance will be driven by our client focus, the continued diversification and expansion of the client base, order flow, products and services, asset classes and geographies.

The first priority is to pursue organic growth opportunities that exist today, to gain market share and increase revenues.

Cross–selling to our buy and sell-side clients also represents an immediate and potentially significant growth opportunity that requires little additional investment. Beyond that we will balance future investments and attractive acquisitions and new home grown offerings that present new opportunities to gain market share, grow revenues, add access and trading capabilities. and deepen client relationships.

While the Global Capital Markets are likely to present further challenges in 2009, I remain quite optimistic about Knights prospects. We are well positioned in the new Wall Street landscape with a client centered focus, attractive offerings and exciting growth opportunities.

In short, I continue to believe that Knight’s future is very bright. So thank you for your time this morning and we will now open the line up for questions. Reika?

Question-and-Answer Session

Operator

(Operator instructions) We will take our first question from Daniel Harris with Goldman Sachs.

Betsy Miller – Goldman Sachs

Good morning guys, it’s Betsy Miller on for Dan Harris.

Steve Bisgay

Good morning Betsy.

Tom Joyce

Good morning.

Betsy Miller – Goldman Sachs

I wanted, on the first question wanted to touch on the non-core equity trading revenues which seem to be extremely high this quarter. Clearly you are benefiting from a few of those, but can you give us some order of magnitude as to which is contributing the most to the growth and which has the potential to move up the ladder of return?

Tom Joyce

And you probably know Betsy, we don’t get into too much granularity on individual segments away from the non-core equity business, but as Steve indicated, if you would, the non-core bit has contributed something like $66 million of our revenues, about 20% of our revenues. We continue to feel very good about the prospects for Knight Libertas in Knight Direct, especially as we expand the Knight Direct offering and move geographically into Europe. So if I had to pick two that we’re most excited about—of course we’re optimistic about all of them—it would be Knight Libertas and Knight Direct.

Betsy Miller – Goldman Sachs

Okay, and with Libertas, was there anything specific in the fourth quarter that you saw around volatility and do you think that that’s sustainable going into the first quarter?

Tom Joyce

I do think it’s sustainable. There was nothing specific in that there was client activity across sort of all the different segments at Libertas trade. Libertas is different from our core equity in that the trading there is a little bulkier. We don’t have the high velocity number of trades, but we do the larger trades. So that trend is absolutely continuing in the first quarter and, again, we’re pretty excited about its prospects. But I wouldn’t say that there was any particular segment. I wouldn’t say how I yield their assets back or any particular one was dominant. It was sort of across the board.

Betsy Miller – Goldman Sachs

Okay and then lastly, on Europe and how you see that building up throughout 2009, how should I think about the growth and the business there, maybe not in terms of revenue but in terms of what the firm is looking to do and the markers to your growth that we should be watching for?

Tom Joyce

Sure, I think the fundamental markers to our growth would be what percentage of our revenue base is coming from international contributions. That would be the one marker that I would look at most closely as we move forward through ’09 and into 2010.

In terms of strategically what we are trying to do, the sales and training team over in London has had a couple of terrific years and continues to grow. In fact, we’re adding headcount. We are very flattered to see Knight become a destination for a lot of talented producers in the industry. So we’ve interviewed a lot of people over there and expect to add headcount. So the core sales and training team over there should experience nice growth as a result of adding staff.

We are very excited about the prospects of moving Knight Link over there. Knight Link, as you know, intersects with broker-dealer clients in the order flow that they had to send to exchanges or originally had intended to send to exchanges and Knight Link can help in that cause of reducing their expenses and improving execution quality.

The Knight Link product is starting to get rolled out over there. We have a grand total of one client we are very excited about, and we expect to add clients over the first half. So we would like to see our electronics trading offerings also expand over there. And we believe that ’09 will be a growth year in terms of getting established over there. We think there will be a lot of growth in the first half and some nice growth in the second half as well.

So those are the two primary focuses: expanding off of the already strong sales and trading team and adding electronic products with the short-term focus on Knight Link. And again, I think the marker will be what percentage of our revenues comes from overseas international sources as we move forward.

Betsy Miller – Goldman Sachs

Okay and then what percent of your revenue was that in the fourth quarter?

Tom Joyce

What percentage of was from international now?

Betsy Miller – Goldman Sachs

Yes, from Europe.

Tom Joyce

About 12%.

Betsy Miller – Goldman Sachs

Okay, thanks guys.

Tom Joyce

Thanks Betsy.

Operator

And we’ll take our next question from Rich Repetto with Sandler O'Neill.

Rich Repetto – Sandler O’Neill

Yes, first congratulations on a great quarter.

Tom Joyce

Good morning, thanks Rich.

Rich Repetto – Sandler O’Neill

I guess the question I have is you have a lot of moving parts and it’s tough to really get your arms around it. I suspect—and give me your thoughts if it’s different—but dollar volumes look like they’ve got to come down.

You talked about realization rates that are much lower, but you still keep putting up 1.5, 1.6 bps and then you have got the competitive landscape that it doesn’t seem like you’re really benefiting from. So just more color, the headwind of the dollar volume versus the other positive things.

Tom Joyce

Let me get to it. I’m trying to describe how I feel about revenue capture. One of my least favorite metrics to guess is the revenue capture. Having said that, in order to probably put a little more meat on the bones, we continue to believe that the way the models behave in sort of a core fashion is that if we had the dips index more like the ones you’ve seen over the last several years instead of the last several months.

We still think revenue capture under that scenario would hover around one basis point, a little above, a little below. Having said that, with the high dips, the higher volatility conditions we’ve experienced, clearly under those circumstances it makes sense to ratchet expectations up to the 1.2, 1.6 range.

So I guess, not to make it more complicated than it already is, but the volatility profile of the market place will sort of move our revenue capture range up and down depending upon whether it’s more volatility or less volatility. I hope that helps a little.

In terms of dollar volumes coming down, we’re not ignorant to the fact that after periods of a lot of activity and a lot of volatility for net of trading, it’s often followed by periods that are quieter, no surprise there. So will dollar volumes come down?

Probably, and obviously we are not immune to the macro trends of the market. What we’re excited about is adding new high-frequency trading models, picking up market share. We know the pie has the possibility of shrinking. We are completely focused on increasing our slice of the pie. So to answer the question on sustainability, we think our performance will be very sustainable.

We are again, not immune to overall macro market conditions, so if volumes contract, I suspect our performance may contract a little. But we’re excited about the opportunity to add new products within that environment and hopefully gain market share. So we, again, as I indicated in my comments at the end, I’m pretty excited about our prospects moving forward almost no matter what the market conditions are due to our ability to bring new products to the market and pick up market share.

Rich Repetto – Sandler O’Neill

And the one part with Madoff, as well as other major market competitors looking like they are at least having turmoil in the press rumors, was there significant uptake in your order flow due to that say in December? And is the composition in the order flow—because you talk new products—changing dramatically.

Tom Joyce

Sure, in terms of the composition of the order flow, as you noticed, we certainly pick up a lot of our market share in listed, so the historical composition of our market share definitely is now more reflective of the overall market share and the market trends in the industry.

Obviously dollar volumes in listed have for a long, long time been the predominant dollar volume in the market due to the fact that listed shares are generally more expensive than NASDAQ shares. So our breakdown of our profile flows is now very representative of the overall markets and (inaudible) listed.

As far as market share goes in general, we made a concerted effort to pick up market share. We did that in a number of ways. Obviously client outreach is the primary one. But also, tweaking, enhancing, sharpening our execution statistics, was also that once, thankfully—like what I’ve said in the past—became a magnet for more order flow.

So we made a concerted effort to pick up market share and you can see our market share trends moving up halfway through the second quarter this year and all the way through the end of the year. Now, did we get a little boost in December because Madoff blew up? We did, but that was December 12, so it didn’t move the needle that much.

Plus, at that point, the market making business that Madoff had slipped over the last few years. Its overall market share in the industry had been decremented quite a bit, so we certainly picked up some clients from them, but it didn’t move the needle a lot. What moved the needle was our overt effort starting at the first half of the year to go after and successfully pick up market share.

Rich Repetto – Sandler O’Neill

And just a last very quick one for Steve, and you mentioned this too, Tom, but the 66 million, I thought that was referred to as revenues from acquisitions and it was 21% of the total. But could you just give us a feel for how much was from, say Libertas versus (inaudible) and the other things that you’ve done and acquired?

Steve Bisgay

Well, we don’t, as you know Rich, typically break out at this point the individual components of our non-core revenues. To be clear, though, just one thing to add on to that, the 66 was from the new acquisitions. The question before was about core versus non-core.

The non-core has that acquisition base and also our London, which is not at all a new acquisition. It is one of our existing business lines. The non-core was roughly about $89 million total, a little bit more than the $66 million we talked about.

Rich Repetto – Sandler O’Neill

Okay, thanks guys and congratulations again on a great quarter.

Operator

(Operator Instructions) And we’ll go to our next call, Mr. Ken Worthington with JP Morgan.

Ken Worthington – JP Morgan

Hi, good morning. First, the New York Stock Exchange has structured a special system and has a new market model. Does the new system present either challenges or opportunities tonight in three areas: execution quality, profitability of your business, and new business opportunities?

Tom Joyce

We obviously compete with and work closely with the New York Stock Exchange as well as NASDAQ. So we certainly watch the events and on those two exchanges/competitors work very closely. So we certainly admire what Duncan is doing down there and certainly think things like secondary liquidity provider will give us an opportunity to grow business frankly.

We think that is a business opportunity. We are always focused on execution quality, as are they, so we watched the proverbial 605 stats closely with magnifying glasses and all the other things one does when watching something closely.

So we are very confident in our ability to continue to deliver very high execution quality statistics. We are very comfortable in our ability to compete against other destinations for doing that. So we know their emotion on a lot of initiatives.

We suspect it may over time hit our profitability. We don’t think there’s anything short-term, but over time we expect to have a business opportunity in secondary liquidity providers, even if we have to on the other side of the client sharpen up our execution quality somewhat. But we’re committed to remaining very competitive and continuing to do the job on behalf of our clients. So sure, they’re in motion, but we are too and we feel pretty good about our ability to compete with those guys.

Ken Worthington – JP Morgan

So, this includes probably nothing positive or negative near-term.

Tom Joyce

Yes, I think that’s accurate.

Ken Worthington – JP Morgan

Okay, thank you. And then secondly, just on Deephaven, what happens here? I know you said in the prepared comments you want to protect investors in Deephaven funds, but from many investors’ perspective, is this still a core business? I know you’ve gated some of the funds but performance has returned to its low in ’08, lost money in the quarter, probably loses money in the next couple of quarters, so what’s the outlook here for this business?

Tom Joyce

Sure, I know as I’ve said in the past, moving forward, Deephaven has to—if it stays within the Knight’s infrastructure—live within its means. It will simply have to adjust and restructure so that its expense base matches up nicely against its revenue base. And I think all of us know that with challenging high-water marks heading into ’09, the revenue base by and large will be the management fees that they charge.

So as we move forward, if the status quo remains then we have to get the expense base down so that again Deephaven, like all the other business entities at Knight, at a minimum, live within its means. Beyond that, we are exploring other situations with our eyes firmly on the investors to make sure that we position the investors to be in the best, safest hands moving forward.

So we have our ears open and are exploring things that we can do to move Deephaven forward most importantly to insure that the investors get treated in the most optimal way possible.

Ken Worthington – JP Morgan

Awesome, that was actually very helpful, thanks very much.

Tom Joyce

Thanks Ken.

Operator

And we’ll take our next question from Mike Vinciquerra with BMO Capital Markets.

Mike Vinciquerra – BMO Capital Markets

Thank you, great results this morning guys.

Tom Joyce

Thank you, Mike.

Mike Vinciquerra – BMO Capital Markets

I have a question for Steve on the compensation line. Steve, you mentioned something about a deferred compensation. It sounds like they actually lowered comp in the quarter, but the numbers were still far below what we had anticipated given the amount of trading revenues you guys were able to generate this quarter. Can you talk about comp ratios on a going-forward basis and what drove this quarter substantially below previous?

Steve Bisgay

I’d be happy to. The comp ratio, when you exclude the impact of Direct Edge, and that’s what we do, is 33%. I did mention that there was a $6.7 million adjustment related to deferred comp on assets. And to be clear, there’s a deferred comp plan, which the assets are carried on the books so the company has lieu of the corresponding liability.

And to the extent that the assets which are in fact in the Deephaven fund, if they were to go up in value then we would recognize revenue and we’d also have a corresponding expense. As the case was for this quarter, they reduced in value and we had a reduction in revenue. That number was about $6.7 million and we had a corresponding decrease in compensation expense in the same amount as well.

When you factor that in and essentially normalize the compensation expense, that takes us to about a 35% pre-tax margin. That is slightly lower than what we had seen over the last trailing quarters. Of course we did have the benefits of operating leverage in the scale. Compensation, certainly you would expect it to go up, but it’s not purely linear, so you would expect you’d have some operating leverage in that number.

Tom Joyce

And just for additional color, when you normalize everything, it’s about 35% of revenues. And just as additional color to give you some sense of what’s going on here, everybody here was paid roughly flat to up a little, so I think it was a pretty good bonus year, and we were very thankful to enjoy that kind of year given the circumstances and the conditions within the market. So we think the ratio is appropriate.

Mike Vinciquerra – BMO Capital Markets

Understood, okay thank you. And one other thing I was looking at is the paying for order flow. Again, you mentioned it was up as a percentage of revenues. But quarter-over-quarter, we’re up about 60% in terms of payment and when I look at the retail dollars reported by some of the broad discount firms who have reported so far, they’re up roughly 15 to 20% in terms of volume December versus September, so the payments going up 60% tells me that you guys must have gained substantial share during the fourth quarter, otherwise this wouldn’t have occurred. Am I reading that correctly?

Tom Joyce

We think you are. I don’t mean to be vague, but we haven’t seen the hard. The proverbial 605 stats I mentioned earlier are monthly and the equally closely watched 606 stats are quarterly. So we don’t have the hard data yet. We know we picked up market share in the institutional equity business. But the 606 stats would be more closely aligned with your paper order flow question and that’s not out yet.

We can tell you that anecdotally we feel like we picked up a fair amount of market share. We know that by focusing on things like our client outreach and execution quality. We’re getting great feedback from our clients. Obviously our trade count is up a lot. So anecdotally we feel pretty good about our market share. I just can’t give you hard confirmation of that because we haven’t seen the 606 stats yet.

Mike Vinciquerra – BMO Capital Markets

Okay, and then Steve, just on the tax rate, should we still be using a 40% rate and ex all the adjustments we need to make this quarter?

Steve Bisgay

I think that’s fair. The rate has hovered on a year-over-year basis about 40 or 41. So whether you use 40 or 41, you’re going to be certainly within the realm.

Mike Vinciquerra – BMO Capital Markets

Thanks very much guys.

Tom Joyce

Thanks Mike.

Operator

And we’ll take our next question from Niamh Alexander with KBW.

Niamh Alexander – KBW

Hi, congratulations on a great quarter. I just wanted to look back on the trading revenue, which was so strong. Can you help me understand how much of that was just pure retail wholesaling for your core retail customer, the retail profit database and maybe some of it that was maybe pure market making in the Knight Link? Is there a way for me to kind of sense how much of this is coming from Knight Link now?

Tom Joyce

Sure, when we looked at our broker-dealer revenues, I would say that it depends on our core of course. We can break down in several ways. We believe Knight Link is sort of a core product for our broker-dealer clients. So we don’t necessarily break that out in the fashion that you asked. But having said that, Knight Link by itself was probably about 23% of trading revenues.

When you look at some of the high-velocity trading strategies we’re developing where we’re leveraging off of models already built but instead of waiting for order flow to come to us, we’re seeking out opportunities in the market. When you look at that, it’s still less than 10% of our broker-dealer revenue number. So the vast majority of the revenues that we derive in our broker-dealer business are directly related to our client relationship.

So it’s well over 90% of our revenues in the broker-dealer business come from our client relationships. Of course we consider Knight Link as very much a client oriented application. And Knight Link itself, as I mentioned earlier was about 23% of our revenues.

Niamh Alexander – KBW

Okay, that’s helpful TJ. And can you just help me on two things? One on the 10% (ph) of maybe you’ll be more proactive or proprietary, how does that compare to the proportion of order for last year or the proportion of the trading revenue last year?

And the second question is to go back to the retail wholesaling business, can you maybe help me understand what you’re seeing, how he quarter progressed, and what you’re seeing maybe into now? We would expect retail order flow to pull back with retail investors pulling back after such a volatile market. Are you seeing that at all? Any help there?

Tom Joyce

Sure, on the new higher frequency models that we started to deploy in ’08, that’s sort of all new. We really didn’t have much of a presence. There wasn’t much of a presence in the contributions in the ’07 revenue numbers. That was new stuff that we rolled out in various times during the course of ’08. And as I mentioned in the formal remarks earlier, we’re very excited about the opportunity to continue to expand that and to look to grow that internationally.

So we’re very excited about prospects of leveraging the quantitative applications we’ve built around here into new ways to contribute. As far as how is January starting, I could do my usual we never talk about how the quarter starts be we feel pretty good about the way things are going. And again, as I mentioned earlier, I’m very optimistic about the prospects that Knight has going forward in the next year or two, certainly.

Niamh Alexander – KBW

That’s helpful, and I know you talked about gaining market share, is there anything specific you can push me towards in the wholesaling business? We’ve gotten the comments about Madoff, but with Citi kind of the automated trading desk perhaps maybe a non-core now with Citadel, was there any kind of difference you noticed in your other competitors for the quarter?

Tom Joyce

Sure, I’m not going to get too involved in that. Of course a lot of that is sort of regurgitating rumors and other people’s opinions about certain things. But I know when we strap our helmets on every morning, we consider Citi to be a very sharp, tough competitor. We have every indication that ATD is a core component of Citibank’s strategy going forward.

UBS ever since they acquired Schwab’s capital markets business, they have been tough and they haven’t let up a lot. So we definitely feel like our three main competitors are still out there going for it every day and that’s why we’ve made a proactive effort to sharpen our competitiveness and go after market share last Spring. And it took a lot of hard work, but it paid off. So we think whatever they do with those other places, we’re in pretty good shape going forward.

Niamh Alexander – KBW

Okay, that’s helpful. Thanks, and just lastly, in terms of your strategic priority TJ, I think you’ve talked about expanding organically and taking shoe (ph) on for options market-making, but with over 400 million in cash even after all that buy back activity, can you update us on where your priorities might be on non-organic growth as you see it.

Tom Joyce

Sure, being the conservative book that we are, we sort of like cash in this environment. We are looking for serendipitous opportunities. We probably would not be going after any kind of an options market-making firm. We’re certainly talking to a lot of talented people in the options market-making realm, but I don’t think we’re making any acquisitions like that.

We’re keeping our eyes open for a lot of things that will enhance our current products. We like our suite of offerings now. We have a vibrant fixed-income business. We have a health foreign exchange business.

Our equity business speaks for itself. So we like our suite of products. And the only acquisitions that we would do would likely be to enhance what we have as opposed to inorganically bulk on something different. So we’re happy, very happy to have a healthy cash position and we look to keep that mostly intact going forward.

Niamh Alexander – KBW

Okay, thanks for taking my question.

Tom Joyce

Thanks Niamh. Reika I think we only have time for one more question.

Operator

Alright, sir. And we’ll take our final question from Roger Freeman with Barclays Capital.

Roger Freeman – Barclays Capital

Hi, good morning. A couple of quick follow-ups on stuff that was discussed already, on Rich’s question on Madoff, I certainly appreciate that and it was only a couple of weeks and they have lost market share. But if you look at the 606 stats for example, it seems like they had a really strong niche in the regional broker’s base, so first of all, what did you pick up then.

And going forward, if you do pick up how does that compare to the rest of your order flow? My gut feeling is regional broker flow should be pretty good flow for you, much better than professional traders and professional traders and heat broker and Knight Link for example, but can you comment a little bit on that and what do you expect there?

Tom Joyce

Sure, before the debacle/tragedy that hit Madoff’s investors in December, they certainly did have a nice bit of market share with the regional broker-dealers and they did a fine job. They definitely saw their market share drift lower over the last several years.

I don’t think as an organization they kept up with folks like us and Citadel and others who really strongly embraced algorithmic quantitative trading, so that’s why we were picking that market share against them anyways. Now that they are banished, we certainly do expect to have a chance to go after the regional broker-dealer order flow aggressively.

We’ve been blessed to have great relationships with them already, so we’re trying to obviously enhance the order flow we get from them. But we’re certainly focused on it. And if your gut is that the order flow is better than others, I would actually agree with that. It’s just hard to quantify it.

But I would think that that is probably good, solid order flow that we and I’m sure Citadel and I’m sure ATD and UBS will be competing for. But we do have some pretty nice, deep, long-standing relationships with those guys so we’re certainly going out and using client outreach, et cetera to go after that new opportunity.

Roger Freeman – Barclays Capital

Okay, great. And on the lines of profitability, now that the fourth quarter obviously ticked up a little bit from the third quarter, in the past when you brought on new clients, Knight Link clients in particular that have had a negative impact now, is that a sign that we actually did not bring on as many in the fourth quarter or is it a sign that your models are actually adapting so much quicker that you still see revenue capture rates increase sequentially while you bring on new clients?

Tom Joyce

Perceptive observation and I think it’s the latter. Thankfully now that we’ve had Knight Link as an ongoing effort for a year-and-a-half now, I think we’re getting better at bringing on new client flow and making the necessary tweaks and adjustments to turn it into profitable flow fairly quickly.

So we’ve been able to produce the yields in that order flow a little more rapidly than we had when Knight Link was more of an immature business. So that’s an interesting observation you made and I think an accurate one that Knight Link and the team there is getting better at producing yields from the order flow than they were when the product was newer.

Roger Freeman – Barclays Capital

Okay, and then just a couple of quick ones on Bond Point, I think you talked about Libertas but not Bond Point. When talking to the heat brokers (ph) it sounds like there’s a lot more demand from retail investors to invest than in bonds now over equities. So is that what drove a lot of the strength in the fourth quarter as well or is it more the cross-selling? And do you see that actual trend yourself that there’s so much more of a demand for fixed income these days?

Tom Joyce

That trend is absolutely something we see, and that was frankly, as I mentioned it a couple years ago when we bought Bond Point, that demographic move would be something we wanted to be in position to capitalize on, and in fact have. Knight Bond Point, I think I mentioned it in the prepared remarks, had something like a three-fold increase year-over-year. Knight Bond Point is doing a fantastic job and it’s both demand from the established clients we have and the cross-selling that’s going on. We’re blessed with about 750 broker-dealers on our network.

And all those broker-dealers have clients who are arguably moving more into a fixed-income bias in their portfolios. So we’re aggressively cross selling. Admittedly Bond Point is still a small base, but a three-fold increase no matter what your base is pretty impressive. And we look for Bond Point to continue to contribute because as you said the retail investor seems to be looking into putting more of their assets into fixed income products.

Roger Freeman – Barclays Capital

Okay, and then lastly, Stephen I don’t think you actually gave the percentage of Knight Link volume and the dollar volume, and if we could have that. And then on the SLP side, (inaudible), there are two active SLPs on the NYSE now. I guess you’re not one of them, correct?

Tom Joyce

That’s correct. We’re in motion. We’re doing the paperwork and all that stuff to get final approval and then we have to set it up. We are not there yet, but we hope to be there soon.

Stephen Bisgay

And to answer your specific question on the SLP contribution, it came out to be about 23% of total gross revs and as TJ mentioned a little while ago, about 31% of the total dollar volumes.

Roger Freeman – Barclays Capital

Okay, I guess I missed that. Thank you very much.

Tom Joyce

Okay, thanks, and in fact, thank you all. I really appreciate you joining us today. I appreciate your attention and we wish you all a wonderful day and look forward to bringing you back here soon with further updates on Knight’s progress. Thanks everybody.

Operator

And that concludes today’s conference. We thank you for your participation and hope that you have a wonderful day.

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Source: Knight Capital Group Q4 2008 Earnings Call Transcript
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